regulation and supervision of microfinance institutions · the regulation and supervision of...

REGULATION AND SUPERVISIONOF

MICROFINANCE INSTITUTIONS

Experience from Latin America,Asia, and Africa

Shari BerenbachCraig Churchill

The MicroFinance NetworkOccasional Paper No. 1

The Regulation and Supervision of Microfinance Institutions

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TABLE OF CONTENTS

TABLE OF CONTENTS .................................................................................................................. i

LIST OF ACRONYMS .................................................................................................................. iii

ACKNOWLEDGMENTS..................................................................................................................v

PREFACE .................................................................................................................................. vii

INTRODUCTION ...........................................................................................................................1

1. AN INTRODUCTION TO MICROFINANCE .................................................................................5

1.1 CHARACTERISTICS OF MICROENTERPRISES ...........................................................................5

1.2 MICROENTERPRISE ACCESS TO FINANCING...........................................................................7

1.3 MICROFINANCE INSTITUTIONS EMERGE TO MEET FINANCING GAP ........................................9

1.4 MICROFINANCE SERVICE METHODS ...................................................................................10

1.5 POTENTIAL SCALE OF MFIS...............................................................................................13Bank Rakyat Indonesia ......................................................................................................14Grameen Bank ...................................................................................................................15BancoSol ...........................................................................................................................17

2. RISK PROFILE AND REGULATORY APPROACHES TO MICROFINANCE INSTITUTIONS............19

2.1 MICROFINANCE RISK PROFILE ...........................................................................................19Ownership and Governance Risk .......................................................................................20Management Risks .............................................................................................................21Portfolio Risk.....................................................................................................................22New Industry Risk ..............................................................................................................23

2.2 REGULATORY APPROACHES TO MICROFINANCE INSTITUTIONS ............................................24

2.3 TO REGULATE OR NOT ......................................................................................................26

2.4 INITIAL STEPS ...................................................................................................................27South Africa.......................................................................................................................27Philippines.........................................................................................................................29

3. REGULATION: EXISTING LAW APPROACH............................................................................31

3.1 CREATING REGULATED ENTITIES.......................................................................................31

3.2 APPLYING TO BECOME A REGULATED FINANCIAL INTERMEDIARY .......................................32Minimum Capital Requirements.........................................................................................33The Continued Role of the Founding NGO.........................................................................34Owners of Microfinance Institutions ..................................................................................36MFI Management and Director Qualifications ..................................................................39

3.3 ISSUES IN CONFORMING TO STANDARD COMMERCIAL BANK REGULATIONS .........................40

3.4 CASE BY CASE SUPERVISION..............................................................................................42

3.5 LESSONS FROM THE FINANSOL CRISIS ................................................................................43Regulatory Issues Affecting Finansol .................................................................................44Crisis and Resolution.........................................................................................................45

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Lessons.............................................................................................................................. 46

4. REGULATION: SPECIAL LAW APPROACH ............................................................................. 49

4.1 NEW LEGAL AND REGULATORY INITIATIVES ...................................................................... 49Peru .................................................................................................................................. 49Bolivia............................................................................................................................... 54The Mutualist Law of French West Africa ......................................................................... 55

4.2 SPECIALIZED INSTITUTION: PROS AND CONS ...................................................................... 56Microfinance Institutions as Deposit Takers? .................................................................... 58Standards of Entry............................................................................................................. 60Capital to Asset Ratios ...................................................................................................... 61

4.3 SUGGESTIONS FOR SPECIALIZED MICROFINANCE INSTITUTIONS .......................................... 61

5. SUPERVISION OF MICROFINANCE INSTITUTIONS .................................................................. 63

5.1 THE HYBRID APPROACH TO MFI SUPERVISION .................................................................. 63Indonesia........................................................................................................................... 64Peru .................................................................................................................................. 64

5.2 SUGGESTIONS FOR APPROPRIATE SUPERVISION .................................................................. 65

5.3 RECOMMENDATIONS FROM INDONESIA .............................................................................. 67

6. RECOMMENDATIONS ............................................................................................................ 69

6.1 SPECIFIC RECOMMENDATIONS TO ADDRESS MFI RISK PROFILE .......................................... 70Ownership and Governance Risk ....................................................................................... 70Management Risk .............................................................................................................. 71Portfolio Risk .................................................................................................................... 72New Industry ..................................................................................................................... 73

6.2 CONCLUSION.................................................................................................................... 73

BIBLIOGRAPHY AND SUGGESTED READING ............................................................................... 75

TABLE OF BOXES

BOX 1: FIRM DISTRIBUTION BY FIRM SIZE ...................................................................... 5BOX 2: ILLUSTRATIVE TYPES OF MICROENTERPRISES ..................................................... 6BOX 3: REGULATORY APPROACHES TO MICROFINANCE SECTOR................................... 26BOX 4: MINIMUM CAPITAL REQUIREMENTS, 1996 (US$).............................................. 34BOX 5: OPERATIONAL COST RATIOS OF SELECTED MFIS (1993) ................................... 42BOX 6: LAWS AND REGULATIONS TO CREATE SPECIALIZED MFIS (1996)...................... 51


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LIST OF ACRONYMS

ADB African Development Bank

ASA Association for Social Advancement

BCEAO Central Bank of the West Africa States

BKD Baden Kredit Desa

BKK Badan Kredit Kecamatan

BRAC Bangladesh Rural Advancement Committee

BRI Bank Rakyat Indonesia

CGAP Consultative Group to Assist the Poorest

COFIDE Corporacion Financiera de Desarrollo

EDPYME Entidades de Desarrollo para la PequeZa y Microempresa

FEPCMAC Federation Peruana de Cajas Municipales de Ahorro y Credito

FMO Nederlandse Financierings-Maatschappij VoorOntwikkelingslanded

GTZ Gesellschaft fur Technische Zusammenarbeit

K-Rep Kenya Rural Enterprise Program

KHL K-Rep Holdings Limited

KURK Kredit Usaha Rakyat Kecil

IDB Inter-American Development Bank

IFC International Finance Corporation

IPC Interdisziplinare Projekt Consult

MFI Microfinance Institution

MIS Management Information Systems

NGO Non-Governmental Organization

NHFC National Housing Finance Corporation

ODA Overseas Development Administration

PFF Private Financial Fund

PRODEM Fundacion para la Promocion y Desarrollo de la Microempresa

ROSCA Rotating Savings and Credit Associations

ROA Return on Assets

UEMOA West Africa Economic and Monetary Union

USAID United States Agency for International Development


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ACKNOWLEDGMENTS

The MicroFinance Network, with the financial support of the British OverseasDevelopment Administration (ODA), the World Bank’s Consultative Group toAssist the Poorest (CGAP) and a private foundation, has undertaken this researchproject to promote a greater awareness of appropriate regulatory and supervisoryapproaches for microfinance. The authors wish to thank the funders of this projectfor their support.

An expert panel of bank supervisors served as advisors to this research. Theircontributions helped to ensure that this study considered the concerns andlimitations of supervisory bodies. Most importantly, they repeatedly emphasizedthat, for the most part, bank superintendents are not particularly interested in smallfinancial institutions that do not pose a significant threat to the stability of thefinancial system. This panel includes:

• Hennie van Greuning, the former Chairman of the South African ReserveBank, currently employed at The World Bank

• Jorge Castellanos, the Colombian Banking Superintendent from 1994-95, nowworks for JP Morgan in New York

• Luis Cortavaria, the former Banking Superintendent of Peru, currently workswith the International Finance Corporation (IFC)

• Christopher Beshouri, a Financial Economist at the United States Departmentof Treasury

The authors are indebted to a long list of other readers and advisors to this projectincluding: Robert P. Christen; Elisabeth Rhyne (USAID); Richard Rosenberg,Joyita Mukherjee and Anne-Marie Chidzero (CGAP); David Wright (ODA); MariaOtero and Rachel Rock (ACCION International); Barbara Calvin and Stefan Harpe(Calmeadow); Janney Carpenter (Shorebank Advisory Services); Jenny Hoffman(Khula Enterprise Finance, Ltd); Mark Wenner (Inter-American DevelopmentBank); Robert Vogel (IMCC); and Walter Zunic (Federal Reserve Bank of NewYork).

We would also like to thank the members of the MicroFinance Network forsupporting this research.


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PREFACE

The MicroFinance Network is a global association of microfinance institutions(MFIs) committed to improving the quality of life of low income communitiesthrough the provision of credit, savings and other financial services. Networkmembers believe that these services should be provided by sustainable andprofitable financial institutions that reach large numbers of clients who are notserved by the traditional banking sector.

This research is designed to serve as a resource for bank supervisors, regulatorsand policy makers. The Regulation and Supervision Project of the MicroFinanceNetwork reviews case experiences in nine countries that have some experiencewith MFIs, and draws conclusions regarding approaches to regulation andsupervision that are suited to the unique characteristics of those institutions.Countries selected for review were identified because of the presence of aMicroFinance Network member and because this sample presents a range ofregulatory responses taken in diverse settings. The principal findings from this deskreview are summarized in this first volume. The country case studies, presented ina second volume, offer detailed analysis of the field experience.

Experiences in Bangladesh, Indonesia and Bolivia provide evidence of the potentialof microfinance institutions to provide financial services on a large scale. Whilethese are exceptional cases, the microfinance community is emulating these modelsof success. Under proper conditions, including an appropriate regulatoryenvironment, there will be an increasing number of successful MFIs in the comingyears. This document hopes that regulators will be proactive in their preparationsfor the microfinance wave. It is not necessary, desirable, or realistic to regulate allmicrofinance institutions. However, if these services include mobilizing voluntarysavings from the general public beyond closed communities where common bondsexist, it is critical that some form of supervision be involved.

The cases highlight two general approaches to regulating microfinance institutions.The situations in Bolivia, Kenya and Colombia show the experiences of regulatingMFIs within the existing regulatory framework, either as a commercial bank or afinance company. These experiences also highlight mismatches between thestandard regulatory framework and the provision of microfinance services. Thecases from Peru, West Africa and Bolivia (again) provide insight into initialattempts to create special categories of laws designed specifically for microfinanceinstitutions.

A third set of experiences, from South Africa and the Philippines, demonstrate alearning process—for MFIs and policy makers—designed to create standards forthe local microfinance industry. While, these efforts are too early in their


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development to have significant bearing on the discussion, they do suggest possiblefirst steps toward identifying an appropriate regulatory approach for microfinance.

This document does not provide a tool kit to tell policy makers how to regulatemicrofinance institutions. There is not sufficient experience or evidence to offerspecific standards, ratios and guidelines. This document outlines the key issuesinvolved in regulating and supervising MFIs as the foundation for discussions, suchas when is regulation necessary and what is the unique risk profile of microfinanceinstitutions.


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INTRODUCTION

The emergence of the microfinance industry presents an unprecedentedopportunity to extend financial services to the vast majority of the economicallyactive population. In developing countries, traditional banks typically serve nomore than twenty percent of the population; the remaining communities historicallyhave not had access to formal financial services. Yet, this non-traditional market isimmense. The World Bank estimates that the potential global market formicroenterprise credit currently stands at about 100 million clients.

In the last twenty years, leading microfinance institutions (MFIs) have devisedappropriate financial service technologies to become profitable financialintermediaries.1 These developments have established the means to extendfinancial services to excluded sectors, thereby laying the groundwork for themicrofinance industry. Just as new agricultural technologies spawned the greenrevolution in the l970s and ‘80s, new financial technologies are producing themicrofinance revolution in the l990s.

In many countries, bank regulators now face the challenge of determining whetherto regulate the emerging microfinance sector at all. If so, regulators need toconsider an appropriate regulatory approach. As unregulated financial entities, thebetter microfinance institutions have had considerable freedom to adapt operatingmethods to serve their target markets effectively. This has led to the developmentof a small but growing number of robust, specialized financial institutions,innovative delivery methods, and an extension of the financial services market.When regulation is warranted, it requires coherent prudential guidelines that willallow the growth of the microfinance sector while protecting the interests of smallsavers and supporting the integrity of the financial sector as a whole.

Many banking superintendents and their staff, central bank officials and personnelfrom other public sector agencies are relatively unfamiliar with MFIs and therecent regulatory developments for microfinance institutions around the world. Asan introduction to the young microfinance industry, the first chapter describes theunique characteristics of microenterprises, the elements of effective microfinanceservices, and the features of successful MFIs. This study gives particular attentionto microfinance institutions that fall outside the set of those already regulated

1 Microfinance institutions (MFIs) assume a variety of institutional forms. While this documentspeaks most frequently about non-profit microcredit programs that create regulated MFIs, otherinstitutional types include government-owned banks that operate microfinance units andcommercial banks that create microfinance subsidiaries. Successful MFIs typically provide arange of financial services to low income communities, such as savings, personal or consumptionloans, housing and enterprise loans.


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financial intermediaries that reach small savers or small farmers, such as creditunions, cooperatives or agricultural banks. To illustrate the potential growth ofmicrofinance institutions, Chapter 1 briefly describes three of the world’s mostsuccessful MFIs: Bank Rakyat Indonesia, Grameen Bank in Bangladesh andBancoSol in Bolivia.

The second chapter examines the unique risk profile of microfinance institutions.This profile provides the framework for the recommendations to regulate andsupervise these distinct institutions, which are presented in the final chapter. Manyof the risk features are applicable to microfinance portfolios of commercial banksas well as to MFIs that have their roots in the nonprofit world. Chapter 2 outlinesthe range of possible regulatory approaches for microfinance and discusses when itis appropriate to regulate MFIs. This chapter also describes exploratory processestaking place in South Africa and the Philippines by microfinance institutions andpolicy makers. These efforts to introduce industry standards represent initial stepstoward identifying an appropriate regulatory approach for MFIs.

The next two chapters describe different approaches to regulating MFIs. Chapter3 analyzes the challenges and opportunities of establishing microfinanceinstitutions within the existing regulatory framework. Important lessons are drawnfrom the experiences of non-governmental organizations, such as PRODEM inBolivia and K-Rep in Kenya, to create commercial banks, and Corposol inColombia to establish Finansol, a finance company.

Chapter 4 reviews recent initiatives to establish special legal or regulatorycategories designed specifically for microfinance. In Peru, Bolivia and WestAfrica, regulation has emerged in response to: a) the proliferation of financialservices being provided by NGOs; and b) the regulators’ interest to introducesound prudential guidelines for this growing sector of the financial services market.These guidelines were established to create an appropriate regulatory frameworkfor MFIs that permits their establishment, yet limits their functions. However, theefforts in all three jurisdictions are too recent to determine if they will achieve thisobjective. The results from these initiatives must be evaluated in due course, oncethere is sufficient experience to assess the costs and benefits—to the institution,regulators and the economy—of special categories for MFIs.

Issues related to the supervision of microfinance institutions are examined inChapter 5. Whether established as a specialized microfinance institution or as astandard commercial bank or finance company, the supervision of MFIs presents achallenge due to their large number of small transactions, lack of conventionalsecurity and decentralized operations. The institutional capacity of the supervisorybody to oversee these unconventional financial intermediaries, and the availabilityof financial resources to do so, are constraining factors. This chapter discussessupervision practices within the context of financial and technical constraints.

The final chapter proposes a set of recommendations for the regulation andsupervision of microfinance institutions. It is important to note that these


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recommendations are theoretical and preliminary based on initial field experience.In the few cases when it is necessary to regulate microfinance institutions,regulation is possible either through exemptions and modifications to existingbanking guidelines or through the creation of specialized categories formicrofinance institutions. The essence of this analysis is to consider the uniquerisk profile of microfinance institutions and to apply prudential guidelinesrigorously where MFIs are vulnerable, but to offer relative flexibility in measuresinitially adopted to control risk features that do not apply to the microfinancesector.


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1. AN INTRODUCTION TO MICROFINANCE 2

As an introduction to the young microfinance industry, this chapter describes theunique characteristics of microenterprises and their vast demand for microfinancialservices. To fulfill this demand, microfinance institutions have devised effectivemethods to provide financial services that are appropriate for this target market,yet circumvent obstacles that inhibit traditional financial institutions from reachingthe micro sector. To illustrate the potential growth of microfinance institutions,this chapter also describes three of the world’s most successful MFIs: the UnitDesa System of the Bank Rakyat Indonesia, Grameen Bank in Bangladesh andBancoSol in Bolivia.

1.1 Characteristics of MicroenterprisesIn developing economies, firm distribution follows a classic pyramid pattern. At thetop of the pyramid there are a few very large corporations, with the number of firmsincreasing as the size of firm decreases, as shown in Box 1.3 In many countries, thebottom two categories, small and micro businesses, comprise nearly 90% of all firms.Most firms fall within the “microenterprise” range, generally employing fewer than fivepeople and using few fixed assets. The microenterprise end of commercial activity is

2 This chapter draws on a confidential report prepared by Bernard Sheahan and Shari Berenbach,“Project Proposal - ADEMI: Dominican Republic.” Caribbean and Central American BusinessAdvisory Service, 1991.3 This point was emphasized by Pedro Jimenez, the Executive Director of ADEMI, amicrofinance institution in the Dominican Republic, in his discussions with the author.

Box 1: Firm Distribution by Firm Size

Large

Medium

Small

Micro


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known as the “informal sector,” meaning that they are generally not licensed or taxed,and do not conform to labor legislation. In many developing countries, this sectoremploys as much as 50 percent of the working population.4 The microenterprisesector grew substantially during the 1980’s as the performance of the formal economyfaltered in many countries. Faced with few employment alternatives, labor marketentrants turned to self-employment or casual employment in the informal sector.

While there is no single definition, most microenterprises demonstrate thefollowing characteristics:

• Employment: Microenterprises employ one to five persons, includingunpaid family members and paid staff.

• Fixed Assets: Firms are labor-intensive with limited fixed assets.

• Location: Many microenterprises are home-based, operate from informalmarket stalls, or are mobile vendors. More established microenterprisesoperate out of commercial locations.

• Marketing & Supply: Microenterprises generally sell to, and buy from,local markets. They are less likely to export their products or rely uponimports than larger firms.

• Management: Microenterprises are owner-operated and use rudimentarymanagement techniques. Most firms do not maintain written accounts.

• Legal Registration: Microenterprises often operate outside the bounds ofthe regulatory framework. These firms may not be legally registered, paytaxes or adhere to health, safety or labor regulations.

Microenterprises operate in all business sectors, including small-scalemanufacturing, service and commerce, as outlined in Box 2.

4 Otero, Maria and Elisabeth Rhyne, eds. (1994). The New World of Microenterprise Finance:Building Healthy Financial Institutions for the Poor. West Hartford, CT: Kumarian.

Box 2: Illustrative Types of Microenterprises

Services Commerce Manufacturing Transportation Street vendors Tailor/seamstress Barbers/hairdressers Snack food sellers Cabinet/furniture making Machine repair Used clothing vendors Metal working Electronic repair Convenience stores Bakery/food processing Rice husking Market vendors Dairy cows Beer production


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The following financial features of microenterprises significantly influence thedynamics of microenterprise lending.

• Limited Capitalization: Since microenterprises are typically labor-intensive, their capital requirements for start-up and expansion ofmicroenterprises are small.

• Rapid Inventory Turnover: The majority of the firm’s assets is workingcapital, which turns over quickly. Many microenterprises meet the profileof the proverbial cash cow, in that they generate steady, consistent earningsfor their owners.

• High Return on Assets: Microenterprises are efficient users of capital. Thereturn per dollar invested may be as high as 100% to 500%.

• Low Leverage: Because microenterprises have difficulties accessing loans,they rely almost exclusively on retained earnings and family support tofinance business growth. Most microenterprises are therefore highlyunder-leveraged.

• Household Business: For many microenterprises, business and householdresources are intertwined into one financial unit.

These characteristics of microenterprises and the level of household povertyassociated with the owners of microenterprises create very specific, yet largelyunmet, demands for microfinancial services. These features suggest that small,short-term loan products are appropriate. The high marginal return to additionalunits of capital allows these firms to pay financial service charges substantiallyabove commercial rates. The next section describes why these demands are unmetand lists commonly used informal sources of microenterprise financing.

1.2 Microenterprise Access to FinancingIn most countries, microenterprises cannot access financing through the standardcommercial financial markets. Although the demand for microcredit is immense, innearly all countries the commercial banking sector has not found this marketsegment attractive for the following reasons:

Perceived Risk: Without legal registration, reliable financial informationor a fixed location, commercial lenders perceive the small borrower ashigh-risk.

Lack of Collateral: With low fixed asset levels and few personal assets,microenterprises cannot satisfy commercial lender collateral requirements.


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High Administrative Costs: The operating guidelines and administrativeprocedures of commercial lenders are designed for large loans. Theseprocedures are prohibitively cumbersome and costly for the scale offinancing required by microenterprises.

Price Structure: Microenterprise lending does not seem profitable forcommercial banks given the significantly higher unit costs of administeringmicroloans and the prevailing market rates of interest.

Legal and Regulatory Constraints: As discussed below, servingunregistered businesses may detract from the financial institution’scompliance with banking regulation.

Social obstacles: Commercial banks generally have avoided providingfinancial services to low-income communities because of social obstaclesthat exclude this population from mainstream society.

Without access to commercial sources, microentrepreneurs instead rely on informalsources of funds, which usually carry a significantly higher cost than formal financialinstitutions. Microentrepreneurs raise the majority of start-up funds through intra-household savings. Individuals may save the initial seed capital during periods of prioremployment. Deposit-taking services that reach the informal sector therefore serve avital function to support start-up capital accumulation.

When not drawing upon their own savings, microentrepreneurs often acquire financingthrough loans or investments from family members. Intra-household financing, whilenot carrying direct finance charges, may be accompanied by non-cash and cash familialobligations, rendering the family loan at times more costly than one provided by aninstitution. In most cases, the business generates financing for enterprise expansioninternally. Earnings are reinvested to permit enterprise growth. This constrainsenterprise growth to the pace that funds are available through profits.

Other important sources of business financing include supplier credit andtraditional informal saving clubs. Supplier credit for inventory or equipmenttypically incorporates a premium over cash prices; this premium is an implicitfinancial charge. Microentrepreneurs also tap traditional rotating savings andcredit associations (ROSCAs), common among poorer households, to financebusiness requirements. While often technically interest-free, funds through thesesaving groups may not be available according to the timing requirements of thebusiness and carry considerable risks. In addition, they often require theentrepreneur to set aside large portions of his or her available savings withoutearning any direct return; the availability of funds is limited to the level invested bythe members.

Moneylenders are the most expensive funding source. Moneylenders make short-term, working capital loans or financing, often to meet personal emergencies. Thecosts vary from country to country. For illustrative purposes, among marketvendors in the Philippines, moneylenders often use a “five for six” system, whereby


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hawkers borrow five at the beginning of the week and pay back six at week’s end(e.g., 20% per week). Outside the marketplace, moneylending rates may rangefrom 10 to 60 percent per month. Because their steep charges may exceed thebusinesses’ return on assets, microentrepreneurs cannot sustain the interest ratescharged. Continued reliance upon moneylenders may decapitalize the enterprise.

1.3 Microfinance Institutions Emerge to Meet Financing GapWhile most commercial banks have elected not to serve the microenterprise sector,over the last twenty years a wide range of microfinance institutions has emerged torespond to this market. Successful MFIs have adapted lessons learned from informalfinance, such as moneylenders and ROSCAs, to provide access to credit and, in somecases, savings services. In many countries, microfinancial services were initiallyavailable from development projects and non-governmental organizations (NGOs) thatengaged in charitable activities to assist the poor.

Of the several thousand NGOs worldwide that now offer financial services, themajority provide financial services as just one of many facets of developmentassistance. These organizations may employ management and staff who are nottechnically prepared for their financial management responsibilities; their creditoperations, which only reach a small number of borrowers, may have problems withportfolio quality. Where these institutions engage in savings mobilization, deposit-taking may be limited to their borrowers and the funds are likely to be deposited withcommercial banks. The majority of NGOs engaged in microfinance services rely uponsubsidized funds, do not engage in financial intermediation, and do not seekcommercial viability.

Nevertheless, from this broad pool of institutions, there is a growing number oforganizations specializing in the delivery of microfinancial services that areeffective financial intermediaries. In some instances, the successful microfinanceinstitution may be a branch of a multi-faceted development organization. In othercases, the MFI was spun-off as a commercial entity from an NGO parent. In agrowing number of examples, microfinance units are being added to commercialfinancial institutions. All these different types of successful microfinanceinstitutions recognize the following features of the micro market:

• Poor households have funds to save; when offered a convenient, safe andliquid facility, savings from this sector can reach a significant volume.

• Credit access can greatly assist microentrepreneurs with cash flowmanagement.

• Microentrepreneurs know how to use credit intelligently.

• Timeliness of loans and consistency of availability of credit is far moreimportant to borrowers than interest rates.

• Access to repeat loans is a powerful incentive for timely repayment.


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• Technical training for borrowers, where employed, must be demand-drivenand carefully adapted to individual situations.

• Borrowers understand and respect a hard-nosed approach to loancollection.

A well-managed and efficient microfinance institution, which may mobilize savingsand uses the appropriate lending techniques described below, can create aprofitable strategic niche in the financial services market. Demand for savingsservices and loan products is high in the micro market. Given the financingalternatives available to the microenterprises, the availability of credit from an MFIis especially attractive. This demand for credit is elastic given the financial featuresof microenterprises.

Borrowers have proven themselves reliable, consistent consumers. The majority ofmicrofinance clients seek repeat loans. Repayment rates in the commerciallyoriented microfinance institutions consistently exceed those of traditional state-owned development banks by a wide margin and in many cases are comparable orsuperior to rates attained by commercial banks. A well-managed microfinanceinstitution can expect to enjoy strong growth and profitability.

While the growth impetus for MFIs has generally come from microenterpriselending, the leaders in the field are now expanding their product range to meet thediverse demands for financial services from low income communities. These newproducts may include savings, consumer and housing loans, emergency lines ofcredit, and fee-based products such as money exchange, wire transfer andinsurance services. Other MFIs have roots outside of enterprise lending, but arealso diversifying their services to low income communities. They may be savings-led financial institutions, like credit unions, or began in the housing loan market.

1.4 Microfinance Service MethodsThe lack of regulation of the microfinance sector to date has allowed institutionsacross the globe to adopt innovative microfinance methodologies. While each MFImakes some adjustments to respond to the particular features of a local economyor culture, there are remarkable similarities in the service delivery approaches usedin the microfinance industry. Specific features of successful microfinance servicesare addressed below.

Credit Features: Most MFIs use a “stepped lending” approach. MFIs initiateborrowers with small, short-term loans. Although the loan sizes vary from country tocountry, nearly all MFIs in developing countries offer initial loans under US$1,000, andmany offer initial loans of less than US$100. If repayment is timely, borrowers canaccess successively larger, longer term loans according to enterprise requirements.5

5 The definition of short-term varies from country to country. At Accion Comunitaria del Peru(ACP), for example, loan terms average eight weeks, whereas at Grameen Bank (Bangladesh)first loans are usually repaid over twelve months.


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Borrowers are encouraged to undertake repeat loans and may receive multiple loansover the span of several years.

The majority of microloans are used for working capital, although as mentioned aboveMFIs are now diversifying into fixed-asset lending and even non-business loans. Creditadministration is conducted quickly. While different organizations have diverse policiesregarding the turn around time on initial loan requests, the period is generally short.Often, MFIs extend repeat loans on the spot or within a few days. The repeat lendingfunction allows MFIs to screen clients and to direct larger loans to proven borrowers.In this way, the MFI establishes a long-term relationship with the client who, in turn,has the incentive to complete his or her obligations to obtain a continuing, and perhapsincreasing, flow of resources.

Appropriate Requirements: The credit process is appropriate for its market. Toissue microenterprise loans, MFIs remove impediments that the formal financial sectorhas established to transact a loan application, such as collateral, financial statements,letters of reference from banks and businesses, and bylaws of the enterprise.

MFIs allow clients with no credit history to establish a track record; like other prudentfinancial institutions, MFIs lend against that credit history. Through this approach,MFIs keep loan applications simple, sidestepping the need for historical financialinformation. Security arrangements are also appropriately conceived. The MFIsecures credit through group guarantees, character references, reliable priorperformance, the viability of the business, and through chattel mortgages whenavailable. When borrowers grow to small enterprise scale, they can point to a reliablecredit history and an adequate asset base to qualify for subsequent loans.

Repayment Discipline: The borrower’s on-time repayment is sine qua non forsubsequent loans. Where available, computerized credit administration systemsprovide loan officers with accurate and current repayment information. SuccessfulMFIs do not tolerate loan delinquency. Generally, clients with late payments arepenalized and they may not be able to access continued loans. This approach, with theaccompanying incentives built into the lending process, is highly successful.Competent microfinance lenders are able to hold delinquency and default to levels thatrival well-performing financial institutions, levels that are easily handled by standardprovisioning policies without detriment to profitability.

Interest Rates: The lending policy of a successful MFI is based on the use of positivereal interest rates that cover the full cost of lending on the understanding that subsidiesare unnecessary to the microentrepreneur and damaging to the institution’ssustainability. Interest charges are calculated to cover the full cost of lendingoperations, sometimes including a surplus for financing further loans.

These relatively high interest rates are appropriate and essential. They are appropriatebecause of the high rate of return experienced by microenterprises. Conventionalwisdom would suggest that low-income people could not pay high interest rates, whenin fact the characteristics of their businesses actually make it possible.


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High interest rates are essential because they make it possible for low-incomecommunities to have continued access to financial services. Since subsidies cannot lastindefinitely, MFIs have to charge a high enough interest rate to cover their costs, bothoperational and financial, if they want to provide these services over the long-term. Toextend the lending market while covering their costs, MFIs must charge significantlyhigher interest rates than the traditional banking sector. This is a function of economiesof scale in loan size. Just as small business loans have higher rates than multinationalloans, micro loans must carry still higher interest rates. Annual real effective interestrates typically fall into the 20 to 60 percent range.6

The importance of high interest rates does not give MFIs liberty to be inefficient and topass on their inefficiencies to low-income clients. Instead of regulating interest rates,however, a more effective approach to ensure that the rates charged by MFIs areappropriate is to encourage competition. This will spur innovation aimed at reducingthe risks and costs associated with microlending.

Savings Facilities: While in most countries NGO microlenders are not legallypermitted to accept deposits, in a small number of cases, particularly in Asia, somemicrolenders are authorized to do so. This is allowed if they maintain a “Chinese wall”between these liabilities and their assets, and if they only collect savings from theirborrowers. This deposit service encourages saving habits and serves as collateral forpotential loan losses. In these cases, MFIs do not use deposits as a source of loancapital and therefore are not financial intermediaries.

Many MFIs initially require compulsory savings from prospective borrowers beforeaccessing loans. Some organizations are changing to a voluntary saving approach,whereby clients contribute deposits to an emergency reserve fund, because of clientdissatisfaction with the hidden financial costs of compulsory savings. For theseinstitutions, deposit-taking may begin as “loans” from their clients. These term notes,which are not guaranteed, offer higher yields than are available to small savers incommercial banks. In these cases, since most clients are net borrowers,superintendents believe that it is not necessary to regulate these institutions.

The provision of savings services is becoming an increasingly important issue in thefield of microfinance. In some regions, either because microfinance services haveevolved out of the credit cooperative movement (West Africa) or because voluntarysavings from borrowers are permitted (Bangladesh), savings facilities are an essentialservice offered by MFIs. In Latin America, however, with the exception of commonbond organizations such as village banks, most NGO microfinance institutions are not

6 For a more thorough discussion of the importance of charging full cost interest rates see:“Occasional Paper No. 1,” CGAP, August 1996, prepared by Richard Rosenberg; “A PositionPaper presented by the (South African) Alliance of Micro Enterprise Development Practitionerson The Review of the Usury Act,” September 1996; and “Exposing Interest Rates: Their TrueSignificance for Microentrepreneurs and Credit Programs,” Carlos Castello, Katherine Stearnsand Robert Christen, 1991, ACCION Discussion Paper No. 6.


13

allowed to accept deposits. The perceived importance of offering a savings service isone of the reasons driving non-profit MFIs to become regulated financial institutions.

Efficient Administration: In successful MFIs, typically less than one quarter of staff isdevoted to administrative functions, and more than 60 percent of all personnel isinvolved in the direct delivery of financial services. The administrative costs of well-managed MFIs, when expressed as a percentage of the average portfolio, arereasonable given the target population, its average loan size, and its fixed administrativecosts relative to the total portfolio size, but are much higher than commercial banks.

When reviewing all types of financial institutions, there is a consistent adversecorrelation between loan size and the administrative costs. Whereas a commercialbank with large corporate clients may have administrative costs of approximately 1 to2% of portfolio, a finance corporation that lends to smaller and riskier projects mayhave administrative costs in the 10 to 12% range. Within this context, many MFIshave administrative costs around 25% over the average portfolio.

Decentralized Credit Delivery: The loan officer’s basic functions are to selectmicroentrepreneurs through personal promotion, propose the amount and terms of theloan, visit the clients regularly, coordinate group guarantee schemes (where applicable),monitor repayments and follow-up on delinquencies. Loan officers select clients basedon site visits and operate in a decentralized manner. The information that loan officerscollect is usually qualitative and subjective, such as assessing contextual elements in thehome, which they are only able to interpret effectively after significant experience. Oneof the greatest strengths of successful microfinance institutions is the credit-assessmentskills of its seasoned loan officers. With microenterprises, credit scoring techniquesand quantitative indicators of risk are neither appropriate nor effective.

Loan officers typically work out of branch offices located close to the target market.During the term of the loan, loan officers regularly visit their clients to evaluate thebusiness and track its development. This approach guarantees continuous contactbetween the loan officer and the borrower, accumulating knowledge and experiencethat is of great importance for the continued livelihood of the program. Loan officersperform outreach, promotion, assist clients to formulate loan requests, and directlysupervise loans at clients’ workplaces. Portfolio management reports allow loanofficers to track on-time repayment. For an MFI to be successful, loan officers need toknow the day a repayment is overdue and respond immediately to delinquent loans.

1.5 Potential Scale of MFIsMFIs that develop effective service delivery methods quickly lend out their initialsubsidized funding. Such organizations recognize that to obtain the maximum impact,to reach cost-effectiveness and to achieve financial viability, they must significantlyincrease the scale of their operations. The challenge faced by such MFIs is to raisesufficient capital to meet the demand for their services while developing theadministrative and management capacity to continue to grow. The demand for capital


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prompts the MFI’s development process. If an MFI elects to establish a regulatedfinancial intermediary to finance its growth by deposits or inter-bank loans, its potentialscale is bounded primarily by its equity base and its management and administrativecapacity.

Bank Rakyat Indonesia, Grameen Bank of Bangladesh and Banco Solidario, S.A.of Bolivia demonstrate that it is possible to deliver microfinancial services on alarge scale. These institutions operate decentralized service delivery methods, asdescribed above, with small average loans (US$560, US$140 and US$660respectively) that are identified, evaluated and disbursed at the local branch level.It is important to note that these three microfinance institutions are all legallychartered financial institutions with a long track record.7 These institutionsdemonstrate the potential that smaller, younger MFIs may soon achieve.

Bank Rakyat IndonesiaBank Rakyat Indonesia (BRI), a century old, state-owned commercial bank, is thelargest provider of microfinancial services in the world. As of October l996, BRI’smicrofinance branches, or Unit Desas, served 3,500 locations with 15.7 milliondepositors (total deposits of US$2.8 billion) and 2.5 million borrowers (total loans ofUS$1.7 billion).8 Of the 43,000 BRI employees, 23,000 are employed in the Unit Desasystem.

BRI Unit Desa dates to the early l970s when BRI established a branch network tosupport subsidized agricultural programs. By the mid-l980s, however, agriculturalsubsidies were depleted. The Ministry of Finance pressed for a significantliberalization of bank regulations that permitted branch units to set their interestrates for loans and deposits. The Unit Desa’s success stems largely from the BRIpolicy to treat each branch unit as a semi-autonomous profit center that isevaluated independently.9 BRI finances its microlending operations throughmarket-rate deposits totally independent from international donor grants. Depositsraised by branch units exceed the lending volume by forty percent. While the UnitDesa system represents only 23% of BRI’s total assets, it generates close to 40%of the bank’s revenue. The Unit Desa system is profitable and generates a 31%average return on equity.

The experience with village-based microfinance institutions in Indonesia dates backmore than 100 years and is part of the Dutch colonial legacy. Particularly in

7 Although BancoSol was only established in 1992, its track record of success begins with itsparent organization, PRODEM, in 1987.8 MicroFinance Network, Member Statistics, January 1997.9 Boomgard, James and Kenneth Angell. 1994. “Bank Rakyat Indonesia’s Unit Desa System:Achievements and Replicability,” in Otero and Rhyne, editors, The New World ofMicroenterprise Finance: Building Healthy Financial Institutions for the Poor. West Hartford,CT: Kumarian.


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Central Java, the Dutch encouraged the formation of village small-holder banks.In the late l960s, during a period of monetary instability and high inflation rates,many of the village small-holder banks faltered. The growth of the Unit DesaSystem, as well as other village-level financial programs, can be understood as anextension of this well-established tradition of local rural financial services.

While BRI is the largest single institution that provides microfinance services inIndonesia, it is not alone. A complex network of private and other state-ownedsmall scale banking institutions has evolved that provide financial services at thesub-district market towns, a combination of sub-district market towns with villageposts or through village small holder banks. Besides BRI, there are a number ofprominent microfinance networks including: BKD (approximately 5,345 villageunits with one million borrowers); BKK of Central Java (approximately 3,525village units with half a million borrowers); KURK (approximately 1,426 villageunits and less than 200,000 borrowers); and several other private and municipallyowned microfinance institutions.10

Grameen BankThe Grameen Bank began in l976 as an experimental project of the ChittagongUniversity in Bangladesh. During this initial project phase, the Grameen Bankbenefited from the operational support provided by Bangladesh Bank (the central bank)and a credit line from state-owned commercial banks. In l983, the Grameen Bank wasestablished under a parliament-approved special charter. Originally, the Grameen Bankwas owned 60% by government and 40% by its landless borrowers. This ownershipdistribution has shifted over time. As of October l996, the Grameen Bank was onlyeight percent government-owned with 92% ownership held by bank borrowers. Thegovernment has board representation, and this serves as the primary method ofoversight of the bank.

The Grameen Bank is dedicated to lending to the rural poor. It operates in nearly36,000 villages and reaches more than 2.1 million borrowers with a total outstandingbalance of around US$200 million as of June 1996.11 While the Grameen Bank hasboth voluntary and compulsory saving schemes, capital to finance the bank’s growth

10 The number of village-owned banks as of year-end l996 was provided by the Cooperative Division ofBRI responsible for their supervision. Estimates for the number of private village banks is dated as ofl992 and cited in “Report on the FID in Indonesia, October 1992.” All other data is as of l991and isderived from, Chaves, Rodrigo and Gonzalez-Vega, Claudio, “The Design of Successful RuralFinancial Intermediaries: Evidence from Indonesia”; World Development Vol. 24, No. 1, pp. 65-78,1996.11 Credit and Development Forum. 1996. “Savings and Credit Information of NGOs (Data ofMarch and June, 1996),” Vol. 2. No. 1.


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has largely come from international donors as grants.12 When needed, the Governmentof Bangladesh has also assisted the Grameen Bank to borrow funds locally.

Grameen Bank lends to small groups of members who are organized into villagecenters of 60 women each. Loans are available for women’s economic activities, homeconstruction and other medium term credit requirements. Credit services are combinedwith other social and economic services that are intended to help the rural landless ofBangladesh build assets and increase income.

Grameen Bank is the most visible microfinance institution in Bangladesh—andperhaps in the world—and it is the country’s only MFI with a parliamentary-approved banking charter. Nevertheless, there are hundreds of other microfinanceinstitutions in Bangladesh. As of June l996, the Bangladesh Rural AdvancementCommittee (BRAC) served 1.4 million borrowers. In addition, approximately400,000 households are served by Proshika, and another 400,000 borrowers haveloans from the Association for Social Advancement (ASA). The Credit andDevelopment Forum of Bangladesh tracks the performance of more than 200 localNGOs that serve the microfinance market. Combined there are more than fivemillion poor households in Bangladesh that benefit from microfinance services, butthe vast majority of the services are provided by Grameen and the top fiveNGOs.13

Grameen Bank’s 2.1 million borrowers is similar in scale to the 2.5 millionborrowers served by BRI in Indonesia. There are, however, a number of criticaldifferences between the two institutions worth noting:

(i) BRI serves a broader, richer, client population including microenterprises,small businesses and employed individuals, while the Grameen Bankfocuses on rural landless households only;

(ii) BRI’s savings services significantly exceed the lending activities which isnot the case with the Grameen Bank;

(iii) BRI is solely a banking facility while the Grameen Bank also pursues otherdevelopment activities that extend beyond core financial services;14

(iv) BRI finances its profitable Unit Desa system through local deposits, whileGrameen Bank operates at about break-even and depends on internationaldonor grants to support its growth.

12 Although the Grameen Bank has relied upon donor grants to fund some of its borrowingrequirements, according Khandker, Khalily and Khan (1994), as of l993 total savings anddeposits mobilized could have funded its lending operations.13 The Credit and Development Forum indicates that the top five NGOs have 3.0 millionborrowers in addition to the 2.1 million borrowers of the Grameen Bank.14 Grameen Bank’s social activities include organizing day care, distributing seedlings and a tubewell program.


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But the similarities are more important. These two organizations both operatewell-disciplined branch networks that delegate authority to the field. They engagein true financial intermediation and have reached impressive scale.

BancoSolThe discussion of leading MFIs would not be complete without a profile of BancoSolidario, S.A., in Bolivia. Although much smaller than BRI or Grameen, withjust 75,000 active borrowers, BancoSol has achieved significant scale compared tothe population of Bolivia (approximately seven million). BancoSol’s clientsrepresent 40% of the banking customers in Bolivia—impressive outreach for abank that has only been in existence for five years.

The story of BancoSol begins with PRODEM, a non-governmental organization.In 1987, PRODEM was created as a joint venture between prominent members ofthe Bolivian business community, who provided seed capital and leadership, andACCION International, a US-based NGO that provided the technology andmethodology. This methodology includes providing small short-term loans forworking capital to solidarity groups of four or five entrepreneurs.

With initial funding from USAID, Calmeadow15 and the Bolivian private sector,PRODEM began lending in 1987. Its early success opened the doors to newfunders and larger grants. By the end of 1991, PRODEM was operationally self-sufficient. It had eleven branches, 116 employees and a loan portfolio in excess ofUS$4 million—yet, it had not made a dent in the demand for financial servicesfrom the informal sector. As an NGO, PRODEM was unable to access sufficientfinancial resources to keep pace with the demand, and was restricted fromproviding additional services to its clients, most notably savings.

In response to these limitations, the directors of PRODEM decided to create acommercial bank, of which PRODEM would be the largest shareholder.PRODEM sold its urban branches to BancoSol and then turned its attention todeveloping financial products and delivery systems for rural areas. PRODEM nowowns slightly more than 30% of BancoSol. Other shareholders include Profund16

and local Bolivian investors.

Although the bank began as a microcredit program, BancoSol is now a financialintermediary. After a year-long pilot project, BancoSol introduced a voluntarysaving service in all branch offices in mid-1994. BancoSol currently funds

15 Calmeadow is a Canadian NGO specializing in microfinance that channeled funding from theCanadian International Development Agency (CIDA) to PRODEM.16 Profund is an equity fund based in Costa Rica that was designed specifically to invest in LatinAmerican microfinance institutions. Profund’s founding sponsors are ACCION International,Calmeadow, SIDI and FUNDES. Other investors now include the International FinanceCorporation (IFC), IDB, Swiss government, Commonwealth Development Corporation,Corporacion Andina de Fomento (CAF) and the Calvert Investment Fund.


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approximately 25% of its loan portfolio by savings mobilization. The rest of itsloan portfolio is funded through inter-bank loans and equity.

BancoSol relies on market pricing. The bank has an excellent loan repayment ratedespite a real annual interest rate of approximately 30% on US dollar loans and45% on Boliviano loans. It is possible to describe BancoSol as both adevelopment organization and a profit-seeking commercial bank; it aims tosucceed by combining both of these goals. Since 1992, profit levels havefluctuated from a low of 5% to a high of 18% return on equity.

Although BancoSol is the largest and best known MFI in Bolivia, the localregulatory environment has encouraged significant competition for themicrofinance market. The Bolivian government has created a new category offinancial institution designed specifically for MFIs. The first institution to qualifyunder this category, Los Andes, has approximately 20,000 borrowers. Othersuccessful Bolivian microfinance institutions include BancoSol’s parent,PRODEM, which provides loans in rural areas to nearly 30,000 clients, and FIEwith more than 14,000 borrowers. Both PRODEM and FIE are also in the processof becoming licensed under this special category, which is discussed in more detailin Chapter 4.

BRI in Indonesia, Grameen Bank in Bangladesh and BancoSol in Bolivia, alldemonstrate the significant impact that may be obtained by successful microfinanceinstitutions. Given the unsatisfied market demand for microfinancial services, thereis every reason to believe that other institutions will meet the challenge of raisingsufficient funds and effectively administering these resources to achieve this levelof scale and impact.


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2. RISK PROFILE AND REGULATORY APPROACHES TO

MICROFINANCE INSTITUTIONS

An appropriate MFI regulatory approach is based on an understanding of the riskprofile of microfinance institutions and the legal and institutional framework of agiven country. In some circumstances, it may be necessary to regulate MFIs tomanage their risk profile effectively. In this chapter we consider the risk profile ofmicrofinance institutions, the range of possible regulatory responses, and theappropriate time to regulate MFIs. While this risk profile explicitly describesinstitutions that have moved from the non-profit to the for-profit sector, many ofthese issues are also applicable to the microfinance portfolios of commercial orgovernment-owned banks. This chapter will also review initial steps taking placein two countries of an education and policy process to identify the appropriateregulatory approach for MFIs.

2.1 Microfinance Risk ProfileMicrofinance institutions hold many risk features in common with other financialinstitutions. For example, MFIs and commercial banks are both vulnerable to liquidityproblems brought on by a mismatch of maturities, term structure and/or currencies.

On the other hand, many risk features of commercial banks are not directly applicableto microfinance. For example, commercial banks are vulnerable to concentration ofrisk when a large loan to a single borrower can put at risk the total bank’s capital orwhen multiple loans are exposed to the risk of a related enterprise group. Insiderlending is another area of concern for commercial banks when managers or owners canuse their influence to extract unsound loans of significant size. Yet, because of thevolume of transactions and their very small size, such issues do not present significantrisks to microfinance institutions.

Many regulatory features adopted to address the risks of standard commercial financialinstitutions do not apply to MFIs. The design of appropriate microfinance regulationshould be based on an understanding of the risk features particular to MFIs andeffective measures to mitigate them. Leading MFIs, such as those described in theprevious chapter, have demonstrated that it is possible to manage these risks effectivelyand that they can achieve excellent performance over many years.

There are four principal areas of risk that are specific to microfinance institutions:ownership and governance, management, portfolio, and new industry. Except forownership and governance risk, which is particular to NGOs creating regulated


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financial institutions, these risks are applicable to microfinance portfoliosregardless of whether the implementing institution is a commercial bank,government bank or an organization with its roots in the non-profit sector.

Ownership and Governance RiskWhile effective external regulation and supervision from regulatory bodies areimportant to the health of the financial system, no amount of external oversight canreplace accountability that stems from proper governance and supervision performedby the owners and directors of financial institutions. For small financial institutions,such as MFIs, which are not likely to receive significant attention from banksupervisors, the importance of governance is heightened.

As a point of reference, the owners of microfinance institutions that have evolved outof the non-profit sector typically include: donors, government agencies or donor-funded agencies from developed countries; local private investors; socially responsiblecommercial investors; and the NGO parent.

Adequate oversight of management: Ownership and governance riskoccur if the owners and directors of the MFI do not have the capacity toprovide adequate management oversight. This is an issue because of thenature of institutions and individuals who typically own an MFI, or who areon its board. For example, the directors of a non-profit organization maynot have the skills and experience to govern a formal financial institution.If investors are socially motivated institutions, like donor or governmentagencies, they may place a priority on the institution achieving socialobjectives. The personnel from these owner-institutions, who are usuallytrained in social and political matters, may not be prepared to exercisesupervision over a financial institution. If investors include the localgovernment or government-owned institutions, MFIs may experiencepolitical interference and be encouraged by these owners to direct credit toa particular region or party members. Even when private individuals investtheir resources, they will likely place the investment to accomplish socialgoals. As a result, they may not hold this investment to the same standardsthat they apply to commercial ventures. Furthermore, the private capitalinvested in the MFI by high net worth individuals may be of symbolicimportance, but may not be financially material for the investor. Withoutsignificant resources at risk, investors lack incentives to monitor theinstitution adequately. MFI management may not face the same scrutinyand be held accountable to the same commercial standards by owners anddirectors.17

17 Christen, Robert Peck. 1997. “Issues in the Regulation and Supervision of Microfinance,” inRachel Rock and Maria Otero, editors, From Margin to Mainstream: The Regulation andSupervision of Microfinance. ACCION International, Monograph Series, No. 11.


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Ownership and organizational structures: In some regulatedmicrofinance institutions, there are unclear ownership and organizationalarrangements involving the non-governmental organization or publicinstitutions that played a role establishing the newly formed regulated MFI.High risk scenarios can develop. If an NGO, which is funded with publicresources and does not have owners, oversees the management anddetermines the policies of the regulated financial intermediary, the socialmission may take priority over financial objectives. Where service deliveryis shared by the NGO and the financial institution, transfer pricing mayobfuscate the true performance of the regulated financial intermediary,hindering bank regulators from gaining an accurate financial profile of theregulated entity.18 Instability at the unregulated parent NGO level couldundermine the stability of the financial intermediary.

Sufficient financial depth: While MFIs may be capable of raising theinitial capital requirements from their founding shareholders, these ownersmay lack financial depth or flexibility to respond to additional calls forcapital as may be needed. In the case of a deterioration of portfolio qualityor other unforeseen difficulties that place pressure on minimum capitallevels, MFIs may have difficulty raising additional capital promptly.Development institutions may require a lengthy approval process to securedisbursement of funds; private sector investors with modest investmentsmay be unwilling to place more funds into a troubled organization. Thismakes the MFI more vulnerable to temporary shocks that could quicklyundermine the financial health of the institution.

Management RisksThe management risks that apply to microfinance portfolios are generated by thespecific service delivery methods required to serve this market. Therefore, they areapplicable regardless of the type of institution that is operating a microfinance portfolio.Other industries with similar service delivery systems (e.g., decentralized operations,high volumes and low returns per loan), such as consumer finance, encounter similarmanagement risks.

Decentralized operational systems: As discussed above, a decentralizedorganizational structure, which permits the delivery of field servicesdirectly at the borrowers or savers’ locations, is central to microfinanceservice methodologies. Such decentralized operating methods presentmanagement challenges in any industry. Poor telecommunications andtransportation infrastructure can compound this challenge. Furthermoredecentralized operating methods generate an environment that can besubject to fraudulent practices if internal controls are not sufficient.

18 This was the case between Corposol and Finansol in Colombia, which is discussed in detail atthe end of the following chapter.


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Management efficiency: Microfinance institutions offer a high volume,repetitive service that operates on low returns per loan. If a branch or unitfalls short in the projected loan volumes, profits can quickly turn to losses.The short term nature of microfinance loans compounds these problems—in many microfinance institutions the dollar value of accumulateddisbursements may double the average portfolio value for the year becauseof high portfolio turnover. If funds are not relent promptly, earnings willsuffer. The quality of management to ensure brisk and timely services isessential to the financial success of microfinance portfolios.

Management information: The backbone of an MFI’s management is itsmanagement information system. While this is true of all financialinstitutions, the decentralized operating methods, the high volume of short-term loans, the rapid portfolio turnover, and the requirement for efficientservice delivery make accurate and current portfolio information essentialfor effective MFI management. Timely and reliable managementinformation is also critical at the branch level. As emphasized in theprevious chapter, loan officers need to know the day a repayment is overdueand respond immediately to delinquent loans. A weak managementinformation system might delay the follow-up on delinquent loans andcould quickly undermine the quality of a microfinance portfolio.

Portfolio RiskThe basic features of the products and services that are appropriate for the micromarket contribute to a different set of portfolio risks than are usually encounteredby commercial lending institutions.

Unsecured lending: Most microlending is unsecured in traditional terms.Microlending is based upon character references, either through a groupguarantee or other methods. Collateral, when pledged, may not be legallyregistered or may have little liquidation value. For example, payrollpledges from a friend or family member of a borrower become meaninglessif the guarantor is laid off. While most MFIs seek to enhance the quality ofthe loan security arrangements where possible, recourse to property titlesand other security may not be available. The non-traditional approachesemployed in microfinance are usually as effective as traditional collateral,but economic shocks could expose the institution if these approaches breakdown in a crisis.

Delinquency management: Some MFIs have undergone significantswings in the on-time repayment of their portfolio. Although the MFI mayhold delinquency levels low for extended periods, precipitous changes indelinquency rates may arise. Strong and continuous supervision of branchoffices is key to the success of microlending. Consequently, laxmanagement practices could prompt a rapid deterioration in performance.


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Liquidity problems can lead to higher delinquencies since the primaryincentive for on-time repayment is access to repeat financial services.Delinquency could also arise from unrealistic growth targets and poor stafftraining. Since operating costs are so high relative to the size of theportfolio, temporary delinquency problems become more serious morequickly than in traditional banking. A spike in the portfolio delinquencyand resultant loan losses could rapidly erode the MFI’s equity base.

Sector or geographic concentration risk: Unlike the risk concentrationtypically borne by commercial banks, where an individual large loan orloans to a related enterprise group may put the bank at risk, MFIs may besubject to risk if many clients come from a single geographic area ormarket segment that is vulnerable to common economic dislocations.Furthermore, unlike other types of financial institutions, which offer avariety of products across many markets, many MFIs have highlyspecialized portfolios that consist solely of short-term working capital loansto informal sector clients. While an institution may have thousands of loansto diverse industries, externalities could affect the MFI’s entire market. Itis important to point out, however, that this risk is largely theoretical.There are very few examples to date of sector or geographic concentrationrisk affecting microfinance portfolios.

New Industry RiskA number of the risks that face the microfinance industry stem from the fact that itstechniques are relatively new and untested. At the same time, formal financial servicesmay also be new to the micro market. These risks should diminish with time as themicrofinance industry and its market mature. In the meantime, this risk is particularlyrelevant to bank regulators since it suggests that they should take a cautious approachto this new industry.

Adequate professional experience: There are few professionals withprior professional banking experience that are also directly familiar withmicrofinance methods. Nevertheless, many of the core banking functionsof a microfinance institution, such as treasury, internal audit andadministration, are similar to those of other financial intermediaries.Because microfinance is a new industry and many MFIs are unable to offerattractive compensation packages, MFIs may have difficulty attractingcapable management talent. This leaves microfinance portfolios vulnerableto inexperienced managers. This problem is exacerbated by the low statusbanking professionals generally attribute to small enterprise services.Commercial banks that operate microfinance portfolios may have similarproblems since the better bankers are likely to be attracted to larger scalelending activities.


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Growth management: MFIs that expand into new markets may face littlecompetition. These institutions can experience dramatic growth in theirinitial years of operation. It is not uncommon for microfinance portfoliosto double in size on an annual basis. Sustaining such growth rates presentsmanagement with the challenges of developing a trained cadre ofemployees, implementing standard policies and procedures, andmaintaining portfolio quality.

New products, services and methodologies: While this industry hasmade considerable advances in the design of appropriate microfinanceproducts and services, the field remains relatively young and untested. It isdifficult to assess whether a new product, service or methodology is an illconceived deviation from an existing methodology or is a breakthrough innew services for the market.

New market: Because MFIs are reaching out to new segments of thefinancial services market, there is little knowledge about this market’sperformance over time. Will demand continue to grow at the same rate,accelerate or taper-off? Market trends or patterns are not welldocumented. And, just as the market is new to MFIs, financial services arenew to the market. Many clients still need to learn the basics of financialplanning and the value of the financial services offered.

Young institutions: A fundamental risk is that most MFIs, whether theyhave evolved from the non-profit sector or they are subsidiaries ofcommercial banks, are relatively young institutions. Therefore, thereremains much to learn about how these institutions behave in a crisis.What is the institutional learning curve? What is its ability to absorblessons and apply them to improve organizational effectiveness?

While “New Industry” risks will resolve themselves as the industry matures, otherrisks must be managed through internal and external means. The experiences ofBRI, the Grameen Bank and BancoSol, as discussed above, demonstrate that it ispossible to manage these risks and that MFIs can grow to significant scale. Thediscussion below examines different regulatory approaches that can be adopted toaddress the risk profile of MFIs effectively.

2.2 Regulatory Approaches to Microfinance InstitutionsThe challenge facing regulators as they consider appropriate regulatory approachesto this sector is complicated by the fact that MFIs range significantly ininstitutional type, scale of operations and level of professionalism. Informalrotating savings and credit associations (ROSCAs), village banks, national orregional non-governmental organizations, credit cooperatives and commercialbanks may all fall within the broad definition of microfinance institutions. The


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regulatory approach in a given country must be consistent with the overall financialsector framework and must consider the variety of institutional types.

Possible responses to microfinance institutions, outlined in Box 3, range from noregulation to full external regulation:

(i) No regulation: Because microfinance has evolved outside of a regulatoryframework, it has been free to innovate and develop non-traditional approachesto providing financial services. In some countries, as the local microfinanceindustry matures, MFIs have established associations or interest groups toinitiate a formalization process. Such efforts may include defining bestpractices and industry standards.

(ii) Pure self-regulation: Self-regulation occurs where the industry develops itsown supervisory and governance bodies. This has occurred primarily throughfederations of credit unions or cooperatives.

(iii) The hybrid approach: In the “hybrid approach”, regulatory authoritiescontract a third party, such as an accounting or consulting firm, to performsome or all of the supervisory functions. This is particularly relevant tomicrofinance since superintendents may not have the technical expertise tomonitor this unique type of institution, nor an interest in paying close attentionto such small financial institutions.

(iv) Existing law: Some countries have opted to regulate microfinance institutionswithin the existing legal and regulatory framework for formal financialinstitutions, but to adapt required ratios and supervisory practices to addresstheir unique risk profile.

(v) Special law: Other jurisdictions have established specialized laws orregulations specific to MFIs or to portfolios of microfinance loans.

The impetus for addressing the microfinance sector has varied widely. In thePhilippines and South Africa, for example, an association of microfinanceinstitutions has initiated a policy dialogue with the government as a first steptoward educating regulators, establishing industry performance standards anddefining an appropriate regulatory approach. These ‘initial steps’ are discussed inmore detail later in this chapter.

In other cases, a single microfinance institution attracts the attention of regulatorsby establishing a regulated entity, such as a commercial bank or finance company,under existing regulatory guidelines. This was the experience in Bolivia, Colombiaand Kenya, and is addressed in Chapter 3. Regulators in West Africa, Bolivia andPeru have established regulations, by law or by order of the bankingsuperintendency, that are designed specifically for microfinance institutions. Theregulation of these non-bank financial institutions is presented in Chapter 4.


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The self-regulation approach, as is typically adopted by credit cooperatives, iswidely applied in countries with an active credit cooperative movement. Importantlessons about self-regulation can be drawn from the credit union experience, but itis not the focus of this research. Experience with the “hybrid approach” is lesscommon, but is represented by innovative approaches to banking supervisionadopted in Indonesia and Peru, and discussed in Chapter 5.

2.3 To Regulate or NotThe vast majority of microfinance institutions are small and informal, and operateas voluntary associations at the local level. It is not feasible nor desirable toregulate them. Regulators should concentrate their attention on institutions thatwould like to offer deposit-taking services to the general public. The fact is, veryfew MFIs have the combination of ownership structures, management, financialdiscipline, information systems and profitability that are necessary to be safedeposit takers. In most countries, there are no more than one or two institutionsthat might warrant regulatory attention. In exceptional cases with more maturemicrofinance industries, such as Indonesia, Bolivia and Bangladesh, there may be agreater number.

In general, it is only necessary to regulate MFIs that mobilize voluntary savings forthe purpose of on-lending. However, there are organizations that mobilizevoluntary savings which do not need to be regulated. For example, it may not be

19 Adapted from the framework presented by Sizwe Tati, Khula Enterprise Finance Ltd. at theMicrocredit Summit in Washington, DC, February 3, 1997.

Box 3: Regulatory Approaches to Microfinance Sector19

Option Initial Steps Self-Regulation

Hybrid Regulation-Existing Law

Regulation-Special Law

Supervisor None Federation Third Party Statutory Body Statutory Body

Features Lobby, Industry-norms

Peer pressureto abide

Jointappointment

GovernmentMandate

GovernmentMandate

Examples Alliance ofMicroenterprisePractitioners inSouth Africa,coalition in thePhilippines

Credit Unions BRI supervisesvillage banks inIndonesia,FEPCMAC inPeru

BancoSol,commercialbanks

PFF in Bolivia,EDPYME inPeru


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necessary to regulate common bond institutions, such as village banks andROSCAs, which are small enough so that all members know each other.

Regulators are primarily responsible for two things: 1) to preserve the integrity ofthe financial system and 2) to protect small depositors. Almost all of the expertswho advised this research felt strongly that as long as MFIs do not mobilizesavings from the general public, they should not be regulated.

Nevertheless, it is possible to make two arguments for regulating credit-only MFIs.First, if the MFI has access to government credit lines for on-lending to themicroenterprise sector, regulation may be required to ensure effective use of publicresources. This argument is questionable since wholesale lenders, whether they arepublic or private, should assume responsibility for monitoring their loans instead ofdelegating that responsibility to bank supervisors.

Second, if the MFI wishes to become a deposit-taking institution in the future,regulators may want to become familiar with the institution and its capacity,thereby laying the groundwork for authorizing deposit-taking at a later date. Thecounter-argument to this point is based on practicality. Most regulatory andsupervisory agencies do not have the capacity or the resources to monitor smallinstitutions that do not pose a threat to the integrity of the financial system.Therefore, this “nice to have” transition arrangement may not be practical in manycountries. Overall, if regulation is deemed necessary for credit-only MFIs, then therequirements and levels of supervision would undoubtedly be less stringent thanfor financial intermediaries.

2.4 Initial StepsIn South Africa and the Philippines, local microfinance institutions have begun adialogue with regulators and policy makers to define the appropriate regulatoryapproach for their environment. Through initial efforts to outline best practices inthe field and to establish industry standards, MFIs are educating regulators andvice versa. Other jurisdictions may want to consider a similar path towardsidentifying an appropriate regulatory response to the dynamic growth ofmicrofinance in their countries.

South AfricaIn South Africa, MFIs have established the Alliance of Micro EnterprisePractitioners. This association provides local microfinance organizations with anopportunity to share experiences and technologies, and it plays an importantlobbying role. For example, the Minister of the Department of Trade and Industryproposed repealing the exemption to the Usury Act, which currently allows MFIsto charge higher than commercial interest rates on loans below R6,000(US$1,350). The government wants to repeal the exemption because it allowsmoneylenders to charge interest rates that exploit the poor. The Alliance has


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appealed to the government not to remove the exemption—and requested that itincrease the loan amount to which the exemption applies from US$1,350 toUS$4,350—because MFIs cannot provide sustainable microfinance services withinthe interest limitations imposed by the Usury Act.

Some members of the Alliance have been working with two government-ownedwholesale development finance institutions—the National Housing FinanceCorporation (NHFC) and Khula Enterprise Finance, Ltd.—to develop codes ofconduct for retail microlending, known as Statements of Sound Practice. Theobjectives of this initiative are to:

• Establish meaningful best practice standards to which retail lending MFIswould adhere in order to qualify for funding from wholesalers;

• Create a framework of self-regulation which would raise standards in theindustry and make it easier to raise institutional funding over time; and

• Develop a long-term framework of appropriate regulation for retail MFIs.

NHFC and Khula have also established an advisory panel that is working with thegovernment on matters pertaining to the MFI industry. This ten-person panelconsists of representatives from NHFC, Khula, the South African Reserve Bank,20

five MFI practitioners, a representative from the private sector and a representativeof the Institute of Chartered Accountants. This Advisory Panel is responsible forapproving an initial draft of the Statements of Sound Practice and any subsequentamendments. It also advises the wholesalers on trends and developments in themicrofinance industry; and will be responsible for developing proposals for a long-term regulatory framework for microfinance institutions.

The South Africa experience stands out as a broad and participatory process toenhance the regulatory environment for microfinance. This case illustrates twopoints made in the previous section. First, South African regulators are notrushing in to license MFIs because they do not mobilize voluntary savings. InSouth Africa, there is a widespread availability of savings services, throughcommercial banks and the Post Office Savings Bank, and therefore most NGOmicrofinance institutions are more concerned with increasing the scale and qualityof their lending activities than offering savings services. The second point is thatthe Advisory Panel initiative was led by the government-owned wholesalers,NHFC and Khula. They have involved the Reserve Bank in the discussions in anadvisory capacity, but the result of this process is likely to be some form ofindustry self-regulation. If this approach is adopted, it will give the wholesalefunders confidence as they extend public resources to MFIs, and yet it will notburden the Reserve Bank with the responsibility of supervising credit-onlyinstitutions.

20 The South African Reserve Bank is responsible for licensing and supervising all commercialand mutual banks, as well as protecting the value of the currency and influencing the monetarysupply. The independence of the Reserve Bank is guaranteed in the South African constitution.


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PhilippinesA similar initiative is being undertaken in the Philippines. The process ofestablishing performance standards for microfinance in the Philippines has involvedassembling a multi-sectoral coalition which as of December l996 consisted of 34member institutions, including:

• Leading NGO microfinance practitioner coalitions;

• The Supervision Unit of the Central Bank;

• The People’s Credit and Finance Corporation (a new wholesaledevelopment finance intermediary for microfinance);

• Two commercial banks that lend to NGOs for microfinance;

• Other government planning and regulatory bodies;

• Private foundations, academic and research organizations; and

• Donor agencies.

Funding for this project comes from USAID, and the project is managed by TSPIDevelopment Corporation, a leading microfinance institution in the Philippines.This two-year project, which started in August l996, is designed to develop andpromote standards for microfinance operations. Standards are expected to helpNGOs build capacity to increase their outreach and access to funds. Microfinanceindustry standards will assist banks and other financial institutions to identifyeffective MFIs. This project will also establish baseline data to help thegovernment define an enabling policy environment. Project activities include thedesign and implementation of a national microfinance survey, regional forums topromote the adoption of performance standards, and a series of trainingworkshops.

The participation of government and regulatory agencies is considered critical tothe project success. Through this project, the Central Bank will evaluate andrecommend to the Monetary Board an appropriate regulatory approach formicrofinance institutions. The National Credit Council, under the Department ofFinance, is involved in this process because it is responsible for coordinating andrationalizing existing government credit policies. And the National Economic andDevelopment Authority, the top economic planning body, is participating toincorporate microfinance into national economic policies. Besides definingperformance standards and promoting their application, an important outcome ofthis project is to involve the appropriate regulatory and governmental officials ingenerating a suitable environment for microfinance institutions.

These initiatives in South Africa and the Philippines suggest possible approaches todefining an appropriate regulatory environment for microfinance. While the effortsin both countries are too recent to evaluate their effectiveness, similar initiativesare worth considering in countries where regulators, policy makers and MFIs needto learn more about each other. The common elements in these two initiatives are:(i) they involve a wide range of participants in the policy process including leading


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MFIs or national microfinance associations, planning bodies and governmentalministries, in addition to regulatory bodies; (ii) they begin by establishing voluntaryindustry performance standards to promote professionalism, uniform practices inthe microfinance industry and peer group comparisons; and (iii) dialogue andanalysis are undertaken before launching microfinance regulation.


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3. REGULATION: EXISTING LAW APPROACH

In a number of countries, successful NGOs have established regulated financialintermediaries within the country’s existing regulatory framework. For example, inthe early l990s, PRODEM of Bolivia and Corposol of Colombia, both non-governmental organizations, spawned regulated financial intermediaries—one acommercial bank (BancoSol) and one a finance company (Finansol)—to providemicrofinancial services. K-Rep, an NGO in Kenya, has recently presented a licenseapplication to create a commercial bank; in the Philippines, TSPI DevelopmentCorporation has submitted an application to establish a thrift bank; while theBangladesh Rural Advancement Committee (BRAC) is preparing to spin off itsfinancial services to a BRAC-owned commercial bank.

This chapter reviews the experiences of regulating MFIs within the existingregulatory framework, with an emphasis on minimum capital requirements,ownership issues and management qualifications. These experiences highlightmismatches between the standard regulatory framework and the provision ofmicrofinancial services. An understanding of these discrepancies suggests ways ofaccommodating MFIs within the existing regulatory framework on a case by casebasis. Finally, this chapter reviews the recent financial crisis that occurred atFinansol in Colombia, and the lessons that this experience suggests for regulatingmicrofinance institutions.

3.1 Creating Regulated EntitiesIn nearly all cases, the primary factor motivating NGOs to shift their microfinancialservices to a regulated financial intermediary is the organization’s desire to ensureits long-term financial and institutional viability through increasing access toborrowed funds, by accepting deposits, entering the inter-bank market or openingaccess to credit lines. Other possible benefits may include heightened credibilitywith both investors and depositors, deposit insurance, and the opportunity toincrease the scale of operations significantly.

The decision for an NGO to establish a regulated financial intermediary involves anumber of tradeoffs. While electing to increase its access to external financialresources, NGOs perceive regulations as limiting their operational and financialflexibility. As a regulated entity, provisioning, write-off and other operatingpolicies would now be defined by bank regulators; and the organization wouldhave to comply with monetary policy controls and reserve requirements. Theorganization would not be able to transfer resources easily between its financial


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operations and any development activities in which it is involved. Although accessto additional funding sources can be a powerful incentive for creating a bank, afterestablishing a regulated financial intermediary, the institution may no longer qualifyfor subsidized funds.

The financial institution would be subject to time consuming reportingrequirements. Estimates of the costs of complying with financial regulations insome countries may range from 30 percent of total profits (United States) to 20percent of total operating costs (Colombia).21 Most MFIs cannot afford theseadditional costs unless the market allows them to increase their interest rates.

If the NGO continues to function, an appropriate relationship must be determined,defining boundaries of operations for the regulated financial entity separate fromthe NGO. This may generate significant management challenges. The new entitywill require experienced bank managers who may bring a different managementculture. In addition, the functions of the NGO and the regulated financialintermediary must be coordinated.

In general, for NGOs, the decision to establish a regulated financial intermediaryindicates significant institutional commitment to providing financial services in acommercially viable and sustainable manner. While NGOs debate the relativeadvantages of establishing a regulated financial intermediary, regulators need toconsider whether it is necessary or desirable to regulate microfinance institutions.

3.2 Applying to Become a Regulated Financial IntermediaryIn Bolivia and Kenya, the process of applying for a commercial bank license wasone of reciprocal education.22 The NGO assumed responsibility for orienting thelocal banking superintendency about the features of microfinance and its potentialin the local economy. In the Kenyan case, representatives from K-Repaccompanied Kenyan regulators to Bolivia to examine BancoSol’s operations first-hand and to discuss its supervision with their Bolivian counterparts. The educationof regulators in both cases also included visits to the field operations of successfulmicrofinance NGOs in their own country. In Bolivia and Kenya, bank regulators,who were familiar with cooperatives and other forms of mutualist societies, nowview microfinance institutions as a means to further extend the financial services intheir country.

Once familiar with the microfinance sector, the process of securing a commercialbank or finance company license was similar in the countries examined. The

21 Author’s conversations with Jorge Castellanos and Hennie van Greuning.22 In Colombia, Corposol bought an existing finance company license, thereby significantlyreducing the hurdle of securing superintendency approval. In Bangladesh, the Grameen Bank,which had been awarded a special charter from congress in l983 had already familiarizedbanking superintendent officials to microfinance.


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standard license application process included the preparation and submission ofmarketing studies, feasibility analysis, financial projections, a plan for branchdevelopment, and lists of proposed managers and directors.

NGOs that have entered the licensing process have encountered several challenges,including finding investors to assemble the minimum capital requirement, the on-going role of the parent NGO, developing effective governance and ownershipstructures, and the appropriateness of management qualifications. Each of these isdiscussed below.

Minimum Capital RequirementsThere are diverse views of the purpose and effectiveness of minimum capitalrequirements. The main reason a financial institution needs capital is to absorbshocks. The more capital a financial institution has, the better able it can sustainlosses. In addition, the more money owners of the financial institution have atstake, the more closely they will monitor the behavior of bank managers. As such,capital serves as an incentive to avoid high risk decisions. Some bank regulatorsuse minimum capital requirements as a tool for controlling the number and type ofmarket entrants—by decreasing the minimum capital level to encourage marketcompetition or increasing the level when regulators believe there is an adequatenumber of financial intermediaries. Where minimum capital levels are high, theycan serve as a barrier to the development of microfinance institutions.

In Colombia, for example, Corposol seriously contemplated establishing itself as acommercial bank, but it found the US$13.8 million in minimum capital required atthe time to be prohibitive.23 Instead, Corposol acquired a finance company with alower capital threshold (US$3.0 million). The only limitations on its functions as afinance company were activities, such as foreign exchange transactions, that theinstitution was not interested in anyway.24 In South Africa, where the minimumcapital requirement for commercial banks is US$11.1 million, the governmentcreated a category for mutual banks with a minimum capital requirement ofUS$2.2 million.25 One of the main purposes of creating this category was toextend the provision of financial services to lower income persons.

Since the minimum capital requirement can also be viewed as a means to establishthe owner’s commitment and financial depth, it can encourage responsible ownerbehavior. Low minimum capital standards—such as the US$25,000 requirementin Indonesia to become an independent village bank—could open the door toinvestors with high-risk practices.

23 The minimum capital requirement to establish a bank in Colombia has subsequently increasedto US$ 22.8 million.24 In Colombia, a commercial finance company can offer checking accounts and savings servicesif its equity base is 60% of the minimum capital requirement of a commercial bank.25 R10 million at an exchange rate of US$1 to R4.50.


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While regulators may set minimum capital standards in accordance with theirobjectives of encouraging competition and low-risk behavior, they must alsoconsider the source of the capital and the proposed ownership structure. Does themoney belong to the proposed owners, are they honest, and why do they want tocreate a financial institution? Because MFI owners may hold social objectives overprofit-maximization goals, minimum capital requirements may not be as powerfulan inducement to sound governance as would generally apply with standardcommercial banking institutions. This is particularly relevant if the founding NGOis an owner of the financial institution since the NGO itself does not have owners.

The Continued Role of the Founding NGOA critical issue for NGOs spawning regulated financial intermediaries is thecontinued role of the founding NGO. The situation with PRODEM/BancoSol andK-Rep are discussed briefly here; the arrangement in Colombia between the NGOCorposol and the finance company Finansol is addressed in detail at the end of thischapter.

Bolivia: PRODEM began as 35% owner of BancoSol. Forty-six percent ofBancoSol’s shares were owned by international institutions, including the Inter-American Investment Corporation, Calmeadow, ACCION International,FUNDES, SIDI and the Rockefeller Foundation; and 19% was invested byBolivian private capital.

26 For locally-incorporated finance institutions; internationally incorporated companies havesignificantly higher capital requirements.27 The range of minimum capital requirements depends on whether the bank is based in oroutside of Metro Manila. TSPI has applied to be a Thrift Bank, which has a minimum capitalrequirement of $1.6 to 10 million. The Philippines also has a category for rural banks with aminimum capital requirement of $80,000 to $800,000.28 This amount is for a Mutual Bank, which is not designed specifically for microfinanceinstitutions. However, the purpose for creating this category was to extend the financial marketsto low-income communities, as is the case for special regulations for MFIs.

Box 4: Minimum Capital Requirements, 1996 (US$)

Country CommercialBank

FinanceCompany

SpecializedMFI

Bangladesh 3.25 million N/A N/ABolivia 3.2 million N/A 1.0 millionColombia 22.8 million 4.0 million N/A.Kenya26 1.3 million 670,000 N/A.Peru 5.5 million 2.8 million 265,000Philippines27 80 to 180 million 4.0 million N/A.South Africa 11.1 million none 2.2 million28


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Upon creating BancoSol, the directors of PRODEM decided to continue tofunction as a microfinance NGO, but to operate in different geographic areas thanthe bank. Initially, PRODEM transferred its profitable urban-based field offices toBancoSol in exchange for share capital and then refocused its mission on twoactivities: (i) developing a sustainable model of rural lending for Bolivia; and (ii)developing new financial services for the microenterprise sector. As the semi-ruraloffices in medium sized towns became profitable, PRODEM sold them toBancoSol for a price established as an arms-length transaction. Today, instead ofselling the profitable rural offices to BancoSol, PRODEM is now considering thecreation of a regulated intermediary under specialized legislation to operate as arural bank.29

One of the reasons the BancoSol/PRODEM split has functioned successfully isthat PRODEM developed its own strategic identity and direction, independent ofBancoSol, including separate (although overlapping) boards of directors, separatemanagement, and strict control of inter-company subsidies. While the twoorganizations collaborate on several fronts, they are operationally independent ofone another. Although PRODEM remains the largest shareholder of the bank,Bolivian law limits the influence of any one shareholder to 20% of the votes. Thisensures that the NGO owner cannot control the behavior of the bank without theagreement of at least two other directors.

In another example from Bolivia, Pro-Credito, the NGO parent of Caja Los Andesand initially its majority shareholder, limits its function to that of a holdingcompany of the financial institution. This arrangement may not be desirable forsome NGOs if they want to continue to offer financial or non-financial servicesthat complement the objectives of the affiliated regulated financial intermediary.

Kenya: The K-Rep NGO intends to take a different approach. After the creationof the K-Rep Bank, the NGO will fashion itself as a microenterprise developmentsupport institution. It will assist microfinance institutions throughout Africa byproviding consulting and product development services, staff training, and market,impact and feasibility research. Its operations will be completely separate from thefinancial institution, and any work that it does for the bank will be on a fee forservice basis.

Although the minimum capital requirement for a commercial bank in Kenya isUS$1.3 million, K-Rep Bank Ltd., will be established in 1997 with a capitalinvestment of US$5.9 million. This level was set by K-Rep in order todemonstrate the strong financial backing of K-Rep bank and to assuage some ofthe concerns of the bank superintendent about licensing a microfinance bank.

The bank will be 25% owned by K-Rep Holdings Limited (KHL), which also“owns” K-Rep the NGO, in a manner of speaking. This structure is designed toallow the NGO and the bank to operate independently while maintaining some

29 This special legislation for Private Financial Funds (PFFs) is discussed in Chapter 4.


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degree of coordination. The size of KHL’s stake is the largest ownership sharepossible under Kenyan law, which forbids any person or institution, except banksand public companies, from owning more than one-quarter of a bank.International, socially motivated institutions will hold additional ownership,including Shorebank of Chicago 18% and Triodos of Holland 8.6%. Publicshareholders of the proposed K-Rep Bank include the International FinanceCorporation and the African Development Bank both at 16.7%, and FMO at 5%.30

In addition, Kwa, the K-Rep employee association (for staff and directors), willhold 10% of the shares.

Owners of Microfinance InstitutionsThis section considers four types of owners of microfinance institutions: NGOs,donors, government and the private sector.

NGOs: In many countries, regulators have guidelines that limit the ownership offinancial service companies by firms engaged in other industries. These limitationsare designed with a purpose similar to the restrictions on loans to related parties:to insulate the financial intermediary from the diverse objectives of the parentcompany. Presently, in most countries, there are no specific guidelines regardingthe ownership of for-profit financial institutions by non-profit organizations; norare there guidelines that preclude an NGO parent of a for-profit entity fromcommingling staffing and services. Yet, many of the concerns that apply to privatecompanies owning financial service operations also apply to NGOs owning MFIs.Ownership arrangements must adopt effective safeguards to limit the risk of“insider dealing.” The design of the relationship must ensure transparency, arms-length transactions and honest transfer pricing. The newly formed regulatedfinancial entities should be operationally independent from the parent NGOs.

The experience from PRODEM/BancoSol in Bolivia demonstrates that distinct andcomplementary roles can be defined, which allow the for-profit and the non-profitentities to work together successfully. However, the outcome of the relationshipbetween Corposol and Finansol in Colombia, in which the NGO was the drivingforce behind the financial institution, proved to be one cause for the problemsdiscussed below. It is important to note that PRODEM was a minorityshareholder of BancoSol (albeit the single largest shareholder) while Corposol wasthe majority shareholder of Finansol. In the Kenyan case, K-Rep is avoiding thisissue altogether since the NGO will not have an ownership stake in the bank.

The proposed ownership of the financial institution must provide stability andadequate management oversight. In Bolivia and Kenya, to qualify for the bankinglicense, regulators required the local NGO to expand its shareholder base to

30 FMO is the Nederlandse Financierings-Maatschappij Voor Ontwikkelingslanded (NetherlandsDevelopment Finance Company)


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include private investors and others with international microlending expertise. Thisis a useful model to replicate, to ensure that the board composition provides anappropriate balance between economic development and profitability.

The question remains: can non-profit organizations, which are capitalized withdonor funding, serve as effective owners of a regulated financial institution? Todate, there is not sufficient experience to conclude one way or another. However,it is useful to consider ownership structures that are being introduced in variousjurisdictions to guard against potential irresponsible owner behavior.

Donors and donor proxies: To date, the primary source of capital formicrofinance has come from donors and government agencies. The internalpolicies of some donor organizations, however, restrict them from having anownership stake in businesses. It is also possible that they may not have thetechnical skills or the organizational structure to supervise an investment in anMFI. Yet donors want to leverage their resources to create models of success thatwill allow the microfinance industry to attract commercial investment. To achievethis objective without becoming owners of microfinance institutions, some donorsare employing a proxy approach, whereby they place grants with third-parties toinvest in MFIs. For example, the Ford Foundation has given Shorebank grants toinvest, in conjunction with its own resources, in the proposed banks of BRAC andK-Rep; and USAID has placed a grant in ACCION’s Gateway Fund to invest inACCION’s affiliates that are creating for-profit financial institutions.

The advantage of this approach is that these shareholders, ACCION andShorebank, can provide the MFI with technical assistance and ensure that theboard includes individuals with microfinance expertise. This link with third-parties, which are involved in microfinance in other parts of the world, also helpsthe new financial institution to learn from a global base of experience. While theirinvestment is non-traditional, if the investment passes through the third-party’sbooks, then they will be sufficiently motivated to ensure that they do not show aloss on that investment. This is particularly true if the grant is conditional on a co-investment by the proxy. Perhaps more importantly, these proxies have theirreputations on the line. Since they exist to promote the microfinance field, theywill do everything possible to achieve that objective. The response of ACCION tothe crisis at Corposol indicates that the reputation of a microfinance supportinstitution is at least as powerful an incentive, if not more powerful, as havingone’s own financial resources at risk.

Profund, a for-profit investment fund based in Costa Rica, represents a variation ofthe proxy approach. Profund is designed to place equity and quasi-equity in MFIsin Latin America. The major shareholders of Profund are primarily socially-responsible private and public investors, including the International FinanceCorporation, the Multilateral Investment Fund of the Inter-American DevelopmentBank, the Andean Development Corporation, the Swiss Government andFUNDES, a private Swiss foundation. Most of Profund’s shareholders are


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primarily interested in receiving a return on their investment, but they also want toplay a key role in developing the microfinance industry.

K-Rep has found an alternative way of turning donor money into ownershipshares. Kwa, the employee association, will receive its 10% ownership stake as agrant in the form of shares from K-Rep Holdings Limited.31 This grant is intendedto facilitate the participation of K-Rep’s employees and board members in thebank’s ownership. Its objective is to reward existing employees for theircontribution to the formation of the bank as well as to establish a performance-based incentive system. The rights to half of the shares will be apportioned toKwa members based on seniority and duration of employment. Of these shares,half will be granted free of charge and the rights to the other half shall be grantedin consideration of cash payments. Kwa will facilitate the payment process byallowing members to pay over a five year period for a charge of 11% per annum.The balance of the shares shall remain in treasury for future issue to new staff andas an incentive bonus to be determined by the KHL board.

Government: In the experiences of Grameen Bank and BRI described in the firstchapter, the governments of Bangladesh and Indonesia respectively servedimportant roles as owners of microfinance institutions. However, state ownershipof banks in general is becoming increasingly discredited. State-owned banks oftendistort financial markets by lending at rates with which private banks cannotcompete, and their credit-assessment record is not impressive. In Argentina forexample, approximately 30% of the portfolio of public sector banks was in arrearsat the end of 1994 compared with only 10% for the private banks. In sub-SaharanAfrica, the World Bank estimates that 15 countries have experienced systemicbanking crises involving state banks.32 This poor track record of the public sectorin banking does not bode well for microfinance which, because of its social agenda,governments may be tempted to use for political purposes.

Private Sector: To date, most private investors in MFIs are prominent localbusiness leaders who placed their funds as a result of a commitment to the socialmission of the institution. The amounts invested typically have not been materialto these local leaders; such owners may not have held these investments to thesame criteria that they would hold other investments. Nevertheless, as MFIsdemonstrate their profitability and scale, private risk capital is expected to enterthe microfinance industry to capture the attractive returns which can be generated.Commercial banks in a number of countries, including Chile, Panama, Indonesiaand South Africa, have begun to establish subsidiaries dedicated to this market,

31 The equity of K-Rep Holdings Limited originally came from donor grants to the K-Rep NGOand retained earnings.32 The Economist, April 12-18, 1997.


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recognizing both the wide spreads which may be earned and the potential scale ofthe micro market.33

MFI Management and Director QualificationsIn addition to ownership issues, regulators must consider the quality of proposedmanagers and board members, and their capacity to administer and govern aregulated microfinance institution. The application process typically includes apresentation of proposed managers and directors. This requirement is intended tosatisfy the regulatory body that the new finance institution will employmanagement with competent professional background in financial intermediation.As stated above, no amount of external oversight can replace the accountabilitythat stems from proper governance. It is crucial that regulators are comfortablewith the skills, motives and commitment of the directors of the proposedinstitution.

Are the original NGO managers prepared to perform these functions? Shouldregulators require that professional bank management be recruited for thisfunction? For MFI management positions, banking experience can contribute mostin the areas of treasury management, administration and internal auditing.However, some commercial bankers may be ill-suited for microlending operations.Success in microlending is tied to familiarity with clients and their needs, relianceon character appraisal, decentralized operations, and fast turnaround on decisions.Some bankers may have difficulty adapting to the culture explicit in this approach.Ideally, all senior staff should be committed to the dual goals of microfinance—economic development and profitability—and should learn how to balance thetwo.

The board should consist of members with a diversity of skills, including financial,legal and managerial expertise, to give effective guidance to senior managementand to critically analyze management’s plans and reports. There is no magicformula for board composition. If board members represent particularconstituencies, they may be unable to act as a member of the board in the interestsof the institution, but instead will be apologists for other interests. This highlightsthe importance of including some independent board members who are chosen fortheir qualities of excellence. Since they do not have a financial stake or represent aspecific constituency, they can be purely responsible to the interests of thecorporation.

33 USAID Commercial Banks and Microfinance Conference, Washington, DC. 1996.


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3.3 Issues in Conforming to Standard Commercial Bank RegulationsFrom the experiences in Bolivia and Kenya, it is possible to highlight mismatchesbetween the standard regulatory framework and the provision of microfinanceservices. These differences emerge from regulation and supervision practices thatare not appropriate for the unique characteristics of microfinance. The implicationhere is not to eliminate or even reduce regulations, but to redefine them in order toprovide regulation that is appropriate for microfinance portfolios. This sectionreviews these important issues and suggests means of resolving them.

Non-secured Lending Restrictions: In many countries, bank regulationslimit the percentage of the portfolio that may be extended as non-securedloans. The types of security available from microentrepreneur clients, suchas solidarity group lending and chattel mortgage on personal assets, are notusually recognized. This drives up the percentage of total assets that maybe considered unsecured. For example, in Bolivia, the Law on Bankingestablishes that the unsecured portion of the portfolio may not exceedtwice the equity of the institution. For BancoSol, with net equity of US$7million and an unsecured portfolio of US$24 million, US$10 million or27% of its portfolio can be considered in permanent non-compliance. Thissuggests a flexible approach to determining the ceiling on loans exemptedfrom the unsecured lending requirement. This same issue arises inconnection with risk-weighting for solvency purposes and provisioningrules.

Reporting: By creating regulated intermediaries, MFIs have to adjust theirreporting significantly. This necessitates a substantial investment in theiraccounting and portfolio management systems, and entails additionalpersonnel and expenses. Reporting formats were originally conceived forbanks with fewer, larger transactions. Although MFIs need the same typesof financial management information as commercial banks, such as liquidityand asset quality, microfinance institutions are more concerned withaggregate indicators. Since their portfolio consists of thousands of littleloans, it is not necessary, nor realistic, to monitor the performance of eachindividual loan. Portfolio reporting formats should be appropriate to thevolume, loan size and term of MFI transactions.

Loan Documentation: The documentation guidelines required by banksuperintendents for commercial loans are not appropriate for microlending.Microlending methods have demonstrated that simple loan applications,perhaps with a basic cash flow analysis, are all that is required. In MFIswith very short-term loans, repeat loans may be automatically approvedwithout a business assessment for clients in good standing. The approvalof a loan application relies more on the client’s repayment history and thequalitative assessment of loan officer than on any quantitative informationin the application. Most microloan documentation does not include creditchecks, business plans or traditional collateral. In some countries,


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documentation guidelines for consumer banking have been adopted, eventhough microloans are typically for commercial rather than consumerpurposes. However, the credit scoring models used in consumer bankingare not applicable to microfinance because of the reliance on qualitativerather than quantitative assessments.

Portfolio Examination: Portfolio sampling methods used by bankexaminers are generally not appropriate for microfinance portfolios. Bankexaminers usually review 30% of a bank’s loans, but this scope is notfeasible in an MFI. In addition, since the loan documentation of unsecuredlending is considerably different from that of conventional lending,examiners would not find the type of information in the files that theywould find at a commercial bank. The loan volume and frequency are solarge that the standard guidelines for determining the sample portfolio, likelarge loans and loans to related parties, are also not appropriate. Formicrofinance, it is more important to examine the trends in the performanceof the portfolio as a whole, as well as for subsets of the portfolio, insteadof a sample of individual loans. The process of examining a microfinanceportfolio should also include a determination that proven lending methodsare being properly implemented and that internal control practices areeffective in rooting out fraud. In fact, if internal and external auditors areperforming their functions effectively, it is possible to question if the valueof on-site inspections by bank examiners outweighs the costs.

Branching: In most countries, banking superintendents must approve theopening of new branch offices. This approval process is intended toprotect against over-branching, which could affect the institution’sprofitability and solvency. This is a valid concern for both banks andmicrofinance institutions. But it is not valid for superintendents to querythe location of new branches. Some superintendents have looked askanceat plans to establish microfinance offices in poor, remote communities thatare perceived as crime-ridden and unsafe. Serving clients in theircommunities during convenient times is a critical element to achieving asound microlending portfolio. Artificial restrictions on the location ofbranch offices and the operating hours could actually increase the risk ofdelinquency. Therefore, regulators should allow MFIs to operate close totheir target market during business hours that the institution has identifiedas most appropriate for that market.

Operational Cost Ratios: Operational cost ratios of microfinanceinstitutions are consistently higher than those achieved by commercialbanks. This is a simple reflection of the microlending methodologydescribed above. The ratios of operational expenses over average portfoliofor the MFIs profiled in Chapter 1 are presented in Box 5. Whenconducting the standard CAMEL rating, bank examiners should recognizethat the small scale transactions are the source of the high ratios. Even


42

with these higher administration costs, microfinance institutions in manycountries still demonstrate satisfactory levels of profitability. The operatingratios of microfinance institutions should be compared with a peer group ofother MFIs rather than with commercial banks. Since most jurisdictions donot have a large enough sample to form a microfinance peer group, it maybe necessary to compare MFIs on a regional basis.

3.4 Case by Case SupervisionIt is possible to address the mismatches between the standard regulatoryframework and the provision of microfinance services through adjustments toexisting banking regulations. In countries where there are not enough MFIs tomerit a full review of the regulation and supervision process, bank regulators canadopt some immediate steps to improve the regulatory environment for MFIssignificantly. These measures are presented below in a quid-pro-quo arrangement.If MFIs surpass accepted guidelines in one area, the recommendation would seekrelaxation in another.

Exceeds capital adequacy requirements / Relax limits on unsecured lending

Most MFIs are not fully leveraged. For example, BancoSol, one of the mostfully leveraged microfinance institutions as of year-end l995, had a risk-weighted capital adequacy of 17 percent. If MFIs exceed the required capitaladequacy measures, and thereby increase their capacity to absorb losses,regulators could relax applicable statutory limits on unsecured lending. Thecharacter-based lending methods used by MFIs will nearly always contribute tohigher levels of unsecured lending.

Demonstrates lower than average delinquency / Modify portfolio documentationrequirements

In many countries, the on-time repayment rates achieved by MFIs exceed thoseobtained by most commercial banks. In those environments, where averagedelinquency has been sustained below normal for a determined period therebyindicating the quality of the portfolio, regulators may consider a more flexibleperspective on appropriate loan documentation. Loan documentation collectedby microfinance institutions, according to the lending methodologies adopted,

Box 5: Operational Cost Ratios of Selected MFIs (1993)

Institution Portfolio(US$ mm)

No. LoansOutstanding

(‘000)

Average LoanBalance (US$)

Admin.Costs %

Avg. Port

Return onAvg.

Assets

Return onAvg. Equity

BRI 937.6 1,897 494 8.5% 1.6% 31.0%Grameen Bank 159.5 1,587 101 14.5% -3.3% -9.7%BancoSol 24.8 46 535 21.0% 1.0% 4.3%Source: Christen, Rhyne and Vogel (1995)


43

are rarely consistent with guidelines adopted by the commercial bankingsystems.

Above average ROA / No penalty for higher operational costs

Because of the elasticity of demand for microfinance services, MFIs mayoutperform the commercial banking sector in terms of revenues and earningsobtained. Yet, given the small size of loans and deposits, the operational costsof MFIs as a percentage of portfolio consistently exceeds those commonlyachieved by commercial banks. If an MFI is able to demonstrate a better thanaverage return on assets consistently, it should not be penalized for its higheradministrative costs.

Provides services to the poor at a reasonable cost / Exempt from usury laws

Although usury laws are intended to protect the most vulnerable sectors of thepopulation, they inadvertently serve to limit access of the poor to financialservices. Because of the higher administrative costs of serving small depositsand loans, it is frequently not possible to provide financial services needed bythe poor and to conduct these below the limits set by usury laws. While thereis reason to question the appropriateness of interest rate limits of any form,financial institutions that provide services to the poor at a reasonable costshould receive exemption in countries where usury laws are in effect.

3.5 Lessons from the Finansol CrisisHow a financial regulator treats failure has important implications for investors anddepositors, for the evolution of local financial markets and, in this case, for thematuration of a new financial industry. Bearing in mind that regulatory authoritieshave as their principal purpose the safety of, and confidence in, local financialmarkets, their approach to the problems of one financial institution will beconditioned by their primary objective—namely, to see that lenders and depositorsget repaid.

Although the establishment of regulated microfinance institutions is a relativelynew phenomenon, one regulated MFI has already experienced a financial crisis:Finansol of Colombia. The situation has taken over a year to work through, sinceearly 1996, and despite overcoming numerous hurdles, Finansol is still in theprocess of reestablishing its operations. Even after an intense period ofnegotiations with the Colombian banking superintendency, two successiveinjections of new equity capital, and the transfer to a new President, it is prematureto declare victory. Another year will be required to prove that the institution hasreturned to sustained profitability. The principal factors contributing to thepredicament and its resolution are discussed below.

Corposol, a Colombian NGO, was established in 1987 by local business leaderswith the support of a US-based technical services organization, ACCION


44

International, to provide integrated training and microcredit to informal sectorbusinesses.34 It grew at an unprecedented rate, from more than 3,000 clients inl989 to nearly 25,000 active borrowers at the end of l992, while maintainingexcellent asset quality. As its need for capital outstripped available resources,Corposol examined ways to tap into financial markets directly by forming aregulated financial intermediary.

In October l993, Corposol and minority shareholders, purchased a financecompany, which they renamed Finansol. By late 1995, Corposol had increased itsequity ownership from 51% to 71% through successive capital increases, leavingminority shareholders, ACCION International, Calmeadow and FUNDES, with acombined 12%; Instituto de Fomento Industrial (IFI), Colombia’s developmentbank, with 7%; and private individuals with 10%.

Regulatory Issues Affecting FinansolUsury Law: Before establishing the finance company, Corposol’s cost of lending(administrative and financial costs) was about 36% of its average portfolio.Interest fees to meet these costs would have exceeded the usury limits at that time.To cover its full operating costs and comply with the usury law, Corposol chargeda training fee with each loan disbursement. This strategy permitted the institutionto raise adequate revenues to operate profitably and remain in compliance with theusury law. After purchasing the finance company, this arrangement continued withthe functions split between the two organizations. Finansol provided the loans andCorposol provided the “training” services. Since Corposol’s revenues in trainingfees were tied to loan disbursement, and credit officers remained Corposolemployees, this arrangement encouraged the approval and disbursement of newloans regardless of loan quality. Finansol had little control over loan generationactivity.

Cap on Growth: Finansol’s financial plan required significant growth in theorganization’s assets. However, months after acquiring the finance company, thebanking superintendent restricted asset growth of all regulated banking entities to2.2% per month to attain monetary policy goals. To avoid this restriction, newloans were periodically transferred from the books of Finansol (the regulatedentity) to Corposol (the unregulated non-profit entity). Corposol also booked newloans during this period. This not only circumvented the superintendent’s policies,but it also undermined the transparency of the financial reporting, and hinderedeffective oversight by owners, board members and bank supervisors.

Governance and Management: The initial team hired to manage the new financecompany consisted of experienced bankers. However, during first year, theoriginal banking team conflicted with Corposol management. The NGO managerwas a particularly dynamic and persuasive individual with grandiose plans for

34 Corposol was initially established as ACTUAR Bogota and adopted the name Corposol in l993.


45

expansion to numerous related and unrelated sectors. Corposol leadershipprevailed; the experienced banking team resigned and a new manager, withallegiances to the NGO’s management, took control of Finansol.

Transparency: The lack of separation—operationally, financially and culturally—between the new financial intermediary and the parent NGO led to a confusion ofpurpose, a lack of independence, and inadequate management and financialinformation to assess the performance of either the operations or the loanportfolio. The minority shareholders of Finansol were unable to understand theperformance of the various joint initiatives given the extensive inter-companytransactions between Finansol and Corposol. As a result, the underlying financialstatus of Finansol was masked.

Crisis and ResolutionIn l995, the Finansol portfolio increased from US$11 million to US$35 million.The rapid growth of new loans included a series of untested loan products thatwere aggressively promoted by Corposol. In addition, management andaccounting systems were inadequate to keep up with the growth. These factorscontributed to a breakdown in the lending methodology and a contamination of theportfolio. In an attempt to mask the deterioration, massive loan refinancing tookplace in the summer of 1995. This only compounded the problem as thecontamination rapidly spread to other borrowers. Although the internal auditinggroup reported such developments to management, their reports were largelydisregarded.

Alarmed by this growth rate and the deteriorating loan quality, the banksuperintendent increased its supervision. ACCION International, a minorityshareholder, conducted its own diagnostic exercise of Finansol in the summer of1995 that illuminated many of the problems, but not the severity nor the urgency.

Finansol’s external auditors issued unqualified financial statements later in the year.This suggests the need for caution in relying solely on audited statements, even ifthey are prepared by the local franchisee of a large international accounting firm.Caution is especially warranted if they are using standard auditing methods ratherthan ones tailored to the unique features of microfinance institutions.

Toward the end of 1995, concerned by an expansion of consumer financecompanies of dubious quality, the Colombian finance authorities decided to furthertighten a restrictive monetary policy and imposed greater provisioningrequirements for such consumer debt. These new requirements, although similarto those applying to microfinance standards in other jurisdictions caught Finansolat the worst possible time. The rapid increase in Finansol’s loan delinquency inlate 1995 triggered provisioning expenses that significantly eroded the capitalposition of the company.


46

At the end of l995, the Board finally took action. An experienced banker washired to analyze and evaluate the situation. Steps were taken to improve loancollections and the delinquency rate on new loans began to improve. In Decemberl995, the banking superintendent required that all operational ties between Finansoland Corposol be severed. Five months later, due to its eroded capital position,Finansol was technically in violation of the Superintendent’s minimum capitalrequirements, and thereby in danger of intervention by the Superintendent. Anintervention probably would have resulted in a rapid sale of assets in order toliquidate the company to repay the outstanding debt.

At that time, Finansol had accumulated obligations of over US$30 million to thelocal money markets, in the form of 30 to 180 day certificates of deposit, only asmall percentage of which would have been covered by the Government’sguarantee fund. However, the bank superintendent decided not to intervene, butinstead permitted a team composed of the new Finansol President, ACCIONInternational, FUNDES, Profund and other minority shareholders to restructureFinansol’s operations and to raise fresh capital.

It was not until late l996 that Finansol’s capital was replenished. The process wascomplicated by several factors: (i) serious financial difficulties at Corposol, whichpreoccupied Corposol’s bankers and made new investment in Finansol difficult, tosay the least; (ii) increasing operating losses, as Finansol was effectively shut downby the superintendent for six months; and (iii) an overall negative economic climateexacerbated by political uncertainty.

Nevertheless, with an additional investment by Profund, the conversion by IFI ofsome of its debt to equity, and some additional investment from Corposol’sbankers in the hope of recovering some of their lost capital, Finansol was broughtback from the brink in December 1996. Corposol, the NGO, was forced intoliquidation.

In early 1997, Finansol started operations again from a much-reduced base, aboutUS$10 million in assets, having made practically no new loans during the lengthyrestructuring process as debt was gradually repaid. Today, Finansol faces thedaunting challenge of rebuilding its portfolio, retraining and restarting its loandistribution and collection systems, and reestablishing itself as a sound financialintermediary.

LessonsThe Finansol crisis demonstrates vulnerable features of MFIs, and suggestssafeguards that can be adopted to mitigate risk. Bank regulators and microfinanceprofessionals can learn multiple lessons from this situation:

• Stick to basics: The first lesson from the Finansol case is that the crisis hadnothing to do with its basic microlending methodology. The methodologyworked fine when it was implemented correctly.


47

• NGO owners: An NGO is not inherently bound to the same standards ofeconomic performance or financial prudence that may be reasonably expectedin the business sector. While this concern is not insurmountable, as theBancoSol case demonstrates, the NGO parent must ensure that it setsstandards appropriate to the financial sector in dealing with its regulatedmicrofinance subsidiary. From the Finansol experience, it is apparent thatNGOs should not be owners of MFIs unless they are separate operationallyand the only financial link is the ownership one. This relationship must betransparent and any financial exchange must include proper transfer pricing.Also, NGOs should not fully control the board and management of an MFI.

• Insider dealing: This case highlights the need for banking supervisors todevelop tools to monitor insider dealing. All insider dealing should be reportedto supervisory bodies in full and the superintendent should have authority tochallenge questionable transactions.

• Auditors: It is premature to discuss bank supervision if audits are not doneproperly. At Finansol, neither the internal nor external auditors properlyperformed their function. Internal auditors reported their findings tomanagement, when in fact they should be reporting to the board. Externalauditors apparently did not have a good understanding of the uniquecharacteristics of microfinance, and therefore were not able to assess thesituation effectively. This suggests a need for training.35

• Hazards of Regulations: It is important to note that regulatory restrictions,such as the usury laws and limits on portfolio growth, constrained the financecompany’s development and contributed to the adoption of inappropriatefinancial practices at Finansol/Corposol. These economic, as opposed toprudential, regulations often have undesirable side effects and should beconsidered with great care.

Important lessons can also be derived from the resolution of the crisis. Notsurprisingly, support was most forthcoming from those institutions with the mostto lose. Local financial intermediaries with outstanding credit lines were veryinvolved in the recapitalization process. They required Corposol to surrender itsmajority stockholder position in Finansol through a debt for equity swap with itsbanks to whom those shares were pledged. International support organizations,such as ACCION, Calmeadow, FUNDES and Profund, had both financialresources and their credibility at stake. As a result, they worked around the clockfor months, lining up new investors and negotiating with regulators. Multilateraldonor institutions were unable to respond directly in a timely fashion, but indirectlytheir financial support was made available through Profund.

35 Under contract with the Consultative Group to Assist the Poorest (CGAP) at the World Bank,Deloitte Touche are currently preparing auditing guidelines for microfinance institutions.


48

This experience suggests the type of ownership mix that may be appropriate formicrofinance institutions. It highlights the importance of having owners who havesomething at risk, who are able to monitor their investment, and who have deeppockets, or can find deep pockets, in the event of a crisis.


49

4. REGULATION: SPECIAL LAW APPROACH

Regulators need to consider if it is necessary to regulate MFIs and, if so, whether aspecial law for microfinance is appropriate. In some cases, regulators haveestablished special categories for microfinance institutions in an attempt to fosterthe provision of financial services to the informal sector. In other situations,regulation has emerged in response to the proliferation of financial services beingprovided by NGOs, and the regulators’ interest to introduce sound prudentialguidelines to this growing sector of the financial services market.

In general, if a special regulatory framework for microfinance institutions isconsidered necessary, it should permit the establishment of MFIs throughappropriate entry standards, but limit their functions in comparison to acommercial bank. While a specialized category for MFIs may not prevent allinstitutional crises, it can protect against crisis situations by establishing anenabling framework for the appropriate growth and development of microfinanceinstitutions. This chapter will present the experiences of three jurisdictions thathave created special categories for microfinance institutions, explore theadvantages and disadvantages of creating a special category including the issues ofdeposit-taking, entry standards and capital to asset ratios, and suggest appropriatecharacteristics for special microfinance regulations.

4.1 New Legal and Regulatory InitiativesThis section presents recent experiences in Peru, Bolivia and West Africa withspecial categories for microfinance institutions.

PeruMunicipal Banks:36 The first law governing microfinance institutions in Peru wasadopted in 1980 to establish publicly owned municipal savings and loans. The lawwas adapted from a German model for municipal bank ownership; the principleowner of a municipal bank is the provincial council. Technical assistance for thecreation and supervision of the municipal banks was financed by GTZ, the GermanTechnical Cooperation agency and provided by Interdisziplinare Projekt Consult(IPC), a German consulting firm. The municipal banks, required by law to be

36 The information in this section was drawn from Burnett, Jill (1995). “Individual Micro-Lending Research Project Case Study: The Caja Municipales of Peru,” CALMEADOW,unpublished manuscript.


50

located outside the capital city, fill a financial service vacuum that emerged fromperiods of hyperinflation, which drove credit cooperatives and mutual loansocieties into bankruptcy.

The first municipal bank was founded in l982 and in l985 a three-way partnershipbetween GTZ, German municipal banks and the Peruvian superintendency wasestablished. In l987, FEPCMAC, a federation of municipal banks was founded.37

The federation plays a key role in the supervision of these institutions, as discussedin the following chapter. Today, there are twelve municipal banks with acombined microloan portfolio of US$25.7 million and a total net worth ofUS$11.0 million. The municipal banks offer a range of services including savingsaccounts and term deposits, as well as pawn, personal, microenterprise andagricultural loans. The minimum capital requirement to establish a municipal bankis US$265,000.

The regulations initially prescribed that each municipal bank must be governed by aseparate board consisting of the following local representatives nominated by themayor: three members of the municipal council; one representative of the church;one representative from the Central Bank or COFIDE,38 the development financecompany; one representative of the chamber of commerce; and one member of thelocal small business community. The pluralistic nature of the board was designedto protect the social mission of the municipal banks. In 1996, the board structurewas changed to lessen the political influence and to include more technicalexpertise. The three representatives of the council were replaced with twoappointees from FEPCMAC and one representative from COFIDE.

The Municipal Bank regulation requires institutions to undertake a gradualdevelopment process. Operations are limited during the first year to simple, lowrisk activities such as savings services and pawn loans. Once the municipal bank isestablished, more complicated services are added. Microenterprise loans areconsidered high risk, and are typically initiated in the third year once the bank hasattained certain performance standards.

Rural Banks. In August 1992, the Peruvian Congress adopted a law to establishrural banks, which are owned by a group of local business leaders from ruralcommunities, and offer a similar service mix in response to their client demands inthe rural areas. Over 16 rural banks are now in operation. Regulatory provisionsfor the rural banks are similar to those which apply to the municipal banks.Experience thus far indicates that the municipal banks are more successful than therural ones. Further research is required to determine if the difference is endemic tothe geographic areas in which they operate, or if it has to do with the supervisoryrole of FEPCMAC, or the technical assistance provided by IPC, or if it is a matterof governance and operational issues.

37 Federation Peruana de Cajas Municipales de Ahorro y Credito.38 Corporacion Financiera de Desarrollo.


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39 While the PARMEC law does not specify a capital adequacy ratio, but MFIs must cover alltheir long term (over one year) assets with long term liabilities and equity.40 Special permission must be received from Banking Superintendent to provide savings services.

Box 6: Laws and Regulations to Create Specialized MFIs (1996)

MunicipalBanks -

Peru

EDPYMEPeru

PFF - Bolivia Village Banks- Indonesia

BCEAO -West Africa -

PARMECLaw

Date Established May 1980 Dec 1995 April 1995 Mar 1992 Dec 1993

Min Capital(US$)

265,000 265,000 1,000,000 25,000 None

CapitalAdequacy

10% 10% 8% 10% None39

Deposit-taking Yes No40 Yes Yes Yes

ForeignExchange

Yes Yes Yes No No

CheckingAccounts

Yes No No No No

Govt. CreditLines

Yes Yes Yes Yes Yes

Security Recognizesjewelry &movables

No definition Recognizessolidaritygroup,movables &jewelry

No definition No definition

UnsecuredCredits

No limits No limits 1% net capital(US$10,000min)

No limits No limits

Maximum LoanSize

5% netcapital(US$12,500)


3% net capital(US$30,000)


N/A.


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Entities for the Development of Small and Micro Enterprises (EDPYME):41

The EDPYME format was developed to diversify the types of regulated financialintermediaries that could serve the micro sector.42 COFIDE, the nationaldevelopment finance company, was instrumental in promoting the EDPYMEregulation. As a second-tier financial intermediary, COFIDE discounts nationaland international credit lines for on-lending through local financial institutions.COFIDE is able to finance up to three times the core capital of a financialinstitution with credit lines. While COFIDE views the informal sector as animportant engine for the country’s economic growth, it is restricted to channel itsfunding only through regulated entities. To date, it has already extended overUS$22.5 million to the municipal and rural banks described above.43

COFIDE considered the ownership guidelines for the municipal and rural bankstoo restrictive for the development of the informal economy because they did notallow the formalization of microcredit NGOs. COFIDE worked with the banksuperintendency over a two year period to develop a more generic institutionalform. The objective of the EDPYME category is to promote the provision offinancial services for persons engaged in small and micro enterprises. The lawdefines small enterprises as having assets of US$300,000 or less and or annualsales less than or equal to US$750,000; microbusinesses have assets of US$20,000or less, and sales less than or equal to US$40,000.44

Since the special regulations were adopted in December l995, as of year-end l996,one institution was established as an EDPYME and 13 other applications are inprocess. Interestingly, while the crafters of the regulations intended the guidelinesas a means of formalizing microfinance NGOs, a variety of companies have filed toestablish EDPYMEs including a local consulting group and a pharmaceuticalcompany that will use the EDPYME to finance their chain of retail pharmacyoutlets. While officials at COFIDE are pleased with this diverse response, bankingsupervisors anticipate that it will be difficult to monitor these various types ofinstitutions with common supervisory practices.

The process of securing an EDPYME license is similar to the methods forestablishing a commercial bank. Besides raising the initial capital, it is necessary topresent a marketing and financial feasibility plan, financial projections, and ademonstration of management experience. The EDPYME license is released whenthe applicant meets a series of conditions, including the investment of the sharecapital, the drafting of bylaws, the development of operations manuals, and therecruitment of management. 41 Entidades de Desarrollo para la Pequena y Microempresa.42 In Peru, the Banking Law of 1991 authorizes the Bank Superintendent to create new classes ofregulated financial institutions. In Bolivia, such a new class of financial intermediary could onlybe created by an act of congress.43 Burnett (1995).44 Rock and Otero, eds. (1997).


53

In principle, EDPYMEs are authorized to accept deposits from the public, but theymust receive special permission from regulators. According to an interview with aformer bank regulator in Peru, an EDPYME is expected to operate for a year ortwo to demonstrate its institutional capacity before it will be authorized to takedeposits.

Throughout the process of developing regulations and operational systems for theEDPYME, a key consideration is to ensure that the supervisory requirementsenforce operational efficiency while accounting for the unique characteristics ofMFIs. For example, the superintendency will not impose documentationrequirements for loans less than US$10,000. The EDPYME regulation is a workin progress. As such, certain aspects are being addressed provisionally. Some ofthe regulation and supervision requirements include:

• the submission of various reports to the superintendency on a daily, weeklyand quarterly basis;

• annual inspections and special inspections according to the criteriadetermined by the superintendency;

• total liability no more than ten times net equity;• portfolio classifications defined by the superintendency, but the provisioning

percentages determined by the institution;• EDPYMEs cannot dismiss the internal auditor without the approval of the

superintendency;• the institution must request authorization before opening new branches.

The legal framework for EDPYMEs leaves much to be addressed, as both thesuperintendency and the new institutions gain experience. The legislation takesinto account that both the government and the MFIs need room to grow, andopportunities to learn from each other. It underscores the importance of atransparent relationship between the two, and the need to maintain opencommunication channels so that future regulations promote the sustained growthof the microfinance industry without compromising the financial markets.

Accion Comunitaria del Peru (ACP): ACP is one of the microfinance NGOs inPeru presently forming an EDPYME, which will be named Accionsol. ACP’sinterest in creating a regulated financial intermediary predates the EDPYMEguidelines and is based on the institution’s need to access additional capital to fundits growth. Initially, ACP intended to establish a commercial bank because itbelieves that it would gain better market acceptance for raising deposits andplacing loans as a commercial bank. When the EDPYME category became anoption, ACP selected this route as an intermediate step toward formalization eventhough it has sufficient capital to qualify as a bank. This transition period, betweenNGO and commercial bank, will allow staff to become familiar with supervisoryrequirements and a for-profit institutional culture.

The total capital to be invested in Accionsol is US$8 million, or nearly 30 times theminimum capital required for an EDPYME. Accionsol will be 70% owned by


54

ACP, the NGO parent, with Profund and ACCION International owning 15%each. ACP’s board of trustees is named as the owner of the portion of shares heldby ACP in response to the superintendency’s concern about NGOs owningfinancial institutions. After the Finansol experience described in the previouschapter, it may not be advisable for an NGO (or in this case its trustees) to havemajority ownership of a financial institution. Regulators are currently exploringvoting rights restrictions to ensure that the financial institution is not driven by theNGO.

Once Accionsol is launched, ACP will continue to operate as an NGO, but will nolonger conduct lending in the urban markets where Accionsol will operate. LikePRODEM in Bolivia, the NGO will develop rural lending methods and other non-financial services. For ACP, the most immediate benefit of creating a regulatedinstitution is access to new sources of capital through lines of credit and theissuance of stock in the capital markets. Access to capital in the form of savingsdeposits is a potential benefit, although ACP does not plan to mobilize savings inthe near future.

BoliviaPrivate Financial Fund (PFF): The PFF category was established as an Act ofthe Bolivian congress in April 1995. The superintendency’s practical experience oflicensing and supervising BancoSol, a microfinance bank under the existingregulatory regime, led to an understanding of the regulatory environment thatwould be appropriate for MFIs. This exposure helped to convince Bolivianregulators that microfinance institutions, which satisfy lower capital requirementsand provide fewer financial services, can effectively meet the financial serviceneeds of the informal sector.

The minimum capital requirement for a PFF is US$1million, or less than one-thirdof that required for incorporating a commercial bank. The banking superintendentbelieves that this start-up capital, together with a strict prudential framework thatestablishes credit limits lower than those for banks, and a prohibition on loans toPFF shareholders and managers, represents a reasonable combination of equitybacking and spread of credit risks. The capital adequacy ratio is 10:1. To avoidrisks that jeopardize their main purpose, and are incompatible with the amount ofcapital involved, PFFs are restricted from offering checking accounts, foreign tradeoperations, equity investments and placement of securities. PFFs are allowed toprovide foreign exchange operations, to receive savings and time deposits, and tocontract obligations with second-tier financial institutions. 45

To address some of the constraints BancoSol encountered regarding the limits onunsecured lending, the PFF guidelines adopted unconventional guidelines for

45 Trigo Loubiere, Jacques, Superintendent of Banks and Financial Institutions in Bolivia, inRock and Otero, eds. (1997).


55

collateral. Specifically, the PFF regulations makes use of a 1937 law thatpermitted financial entities to accept peer group and personal guarantees, andmovable properties (e.g., jewelry, furnishings, appliances) as collateral. Byadopting this creative approach to loan collateral, the PFF is able to expand accessto regulated financial services substantially.

At the time of the PFF law’s passage, a number of NGOs had already submittedapplications to the bank superintendent. As of year-end l996, there were fouroperating PFFs. Private Financial Funds are currently supervised by the bankingsuperintendency, however a special unit may be set up to supervise microfinanceinstitutions (perhaps including BancoSol) once there are sufficient numbers.

Los Andes: Caja de Ahorro y Prestamo Los Andes (Los Andes) was awarded itsPFF license in July 1995, transforming Pro-Credito, an NGO, into the first PrivateFinancial Fund. Since its inception in 1991, Pro-Credito benefited from thesupport of the German government, which financed technical consulting servicesfrom IPC. Pro-Credito was firmly committed to launching a regulated financialintermediary and since the outset had established the reporting and administrativesystems that would allow it to conform easily to regulatory guidelines. IPC alsoserved as an advisor to the bank superintendency, which further facilitated thetransition from NGO to regulated entity.

Los Andes is owned 50% by Pro-Credito, 25% by international organizations,such as the Swiss Technical Corporation and Corporacion Andina de Fomento,and 25% by private capital. After creating the PFF, Pro-Credito’s sole function isto serve as a holding company of Los Andes—it does not continue to provideoperating services.

The Mutualist Law of French West Africa 46

During the l980s, the banking crisis in the West Africa Economic and MonetaryUnion (UEMOA) led to the virtual disappearance of banks from rural areas andprovincial towns. To meet the gap in financial services, a wide range of informalfinancial institutions emerged, offering savings and credit services.

As these informal financial intermediaries grew in number and scale, the CentralBank of the West Africa States (BCEAO) sought to establish an appropriateframework for their regulation.47 In 1992-1993, with the technical support fromthe Canadian Societe de Developpement International Desjardins, the BCEAOimplemented a saving and credit union regulation project to prepare draftlegislation for a new law. The proposed law was adopted by the Council ofMinisters of the UEMOA in December 1993. Following this adoption each 46 This section was prepared with the assistance of Anne-Marie Chidzero from CGAP.47 According to the Analysis of Draft Legislation Governing Mutual and Cooperative Savingsand Credit Institutions, an internal World Bank report dated June 3, 1996, there are an estimated1,000 institutions that would be affected by the law.


56

signatory country must ratify the law at the national level. As of March 1997, allcountries have ratified the law except Benin.

The legislation is quite detailed. It addresses the organizational structure,management standards, financial guidelines and the process of approval,recognition and affiliation with apex institutions. Most importantly, the law wasdesigned to promote credit cooperatives and local, regional and national apexcooperative associations. Credit cooperatives are defined as those in whichmembership is unrestricted and voluntary, the “one member, one vote” ruleapplies, and the returns on share capital are limited. The law also requiresregistered institutions to comply with the usury law, which places a ceiling oninterest rates at twice the discount rate, which is currently 8 percent. Themonetary authorities recognize that this restriction impedes the development ofMFIs and are proposing to the Council of Ministers mechanisms to remove theceiling.

To be recognized under the law, each microfinance institution must adopt thecredit union structure within a two year period. If an institution chooses not to doso, it must receive special permission to operate from the Ministry of Finance ofthe respective country. It is unclear whether permission would give MFIs legalrecourse against bad credits; in fact, it is unclear what the legal status of these“permitted” but not mutualist MFIs would be.

The law has prompted considerable debate because many of the MFIs operating inthis region do not meet the definition of a credit cooperative and do not intend todo so. There is concern that these organizations are being boxed into a legalframework that is not consistent with their institutional objectives. While this is agood credit union law, it does not allow for the development of different types offinancial institutions. Another challenge posed by the new law is that it stretchesthe human and technical capacity of supervisory bodies as they attempt to monitorthe microfinance sector.

4.2 Specialized Institution: Pros and ConsWhereas in Peru and Bolivia, a specific institutional form to serve the microfinancesector was adopted, regulators in other countries have no intention of followingthis route. The decision to establish a specialized MFI category can only bedetermined from the regulatory framework and the features of the microfinanceinstitutions in each country. This is not just a regulatory issue. It depends on thecountry’s approach to financial sector development. This section reviews some ofthe advantages and disadvantages of creating a separate category, including theissues of deposit-taking, entry standards and capital to asset ratios.

Microfinance institutions are clearly different than other financial institutions. Toregulate MFIs, it is possible to either make exceptions within the existingregulatory framework or to create a special category of financial institution that is


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appropriate to their unique characteristics. Some pros and cons of establishing aspecial category for MFIs are discussed below.

Cons. Regulators who argue that a special category for microfinance is notnecessary stipulate that only deposit taking institutions should be regulated.Therefore, if an MFI wants to mobilize voluntary savings from the general public,it should comply with the standard set of regulations. This argument, however,overlooks the unique risk profile of microfinance institutions. This approachwould either require a significant number of regulatory adjustments because of theserious mismatches outlined in the previous chapter; or it would require MFIs tochange their methods to conform to traditional financial practices, which wouldultimately alienate their market.

Those who caution against a special financial category argue for a simple, lessintrusive regulatory environment. They suggest that a specialized class wouldunnecessarily limit the functions that the intermediary may want to assume at alater date. To resolve this potential problem, in Peru, financial institutionsregardless of type can apply to provide specific services once they have theminimum capital required for institutions that are authorized to provide thatservice.

It is also possible to argue that a special regulatory category for MFIs createsdisincentives for banks to lend to this sector. In some countries, such as Chile,Panama, Indonesia and South Africa, private banks have established microfinancesubsidiaries. This argument contends that, if banks can be encouraged to serve thismarket, this method of extending the financial system is less risky and easier toregulate than encouraging non-profit organizations to create financial institutions.In most countries, however, banks have not expressed an interest in the micromarket.

Pros. The primary advantage of creating a special category is to authorizeinstitutions to provide a reduced range of financial services, without becoming abank, in exchange for a lower capital requirement. This permits an MFI to pursueits goals, but bars its entry into complex services for which the institution may notbe well prepared.

A special category allows MFIs to maintain their distinct characteristics andeffectively serve their target market. A category of financial institution designedfor the specific features of low income communities links the informal sector andthe mainstream economy. If microfinance institutions, because of theirdemonstrated commitment to their target market, can earn the trust of low incomecommunities, it is possible that they will be effective in bringing savings from underthe mattress and into circulation, as evidenced by BRI’s impressive savingsmobilization efforts.

By creating a special category for MFIs, regulators heighten the visibility of themicro sector. This will attract attention and create interest in forming new


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financial institutions. As shown in the Peruvian case, a special category thataccommodates various institutional types encourages innovation, such as the useof the EDPYME category to finance a chain of pharmacies. A special categorycan also encourage microcredit NGOs, which are not already doing so, to thinkseriously about self-sufficiency.

In the countries that have established a special category, there has not yet beensufficient experience to assess if it has indeed effectively added depth to thefinancial system without weakening it. It is also too early to tell if the supervisorybodies will have the resources to effectively monitor these new institutions, orwhether they will develop alternative ways of supervising microfinance institutions.

Microfinance Institutions as Deposit Takers?The authorization of deposit taking services is perhaps the most pressing issue inthe debate about the creation of a special category for MFIs. The two argumentsfor allowing MFIs to mobilize savings are:

i) The provision of deposit services is a vital need for the informal sector, butas NGOs the majority of MFIs are not in a position to offer savingsservices.

ii) Microfinance institutions that want to become regulated are usuallymotivated by the need to finance their growth by mobilizing deposits oraccessing the capital markets in other ways.

Should microfinance institutions, which are not commercial banks, be authorizedto collect deposits from their borrowers, the general public or both? The PFF lawin Bolivia authorizes MFIs to receive savings and time deposits from the generalpublic. The BCEAO guidelines permit deposit-taking, but limit the institution’sloan portfolio to twice the total value of member deposits.48 An EDPYME in Peruis not restricted from mobilizing savings, but it must receive special authorizationfrom the bank superintendent to do so.49

As mentioned above, very few NGOs have the right management, financialdiscipline, information systems and profitability to be safe deposit takers. Inaddition, no institution should be allowed to take savings if its ownership andgovernance structure is not appropriate for that function. If an institution iscapitalized with donor money and retained earnings, and therefore does not haveowners in the traditional sense, then it is hard to justify the authorization ofdeposit-taking services.

48 Under the BCEAO law, member deposits are treated as shareholder equity. Loans to any onemember cannot exceed ten times the value of that individual’s savings.49 It is important to note that a primary motivation behind the creation of the EDPYME categorywas to allow COFIDE, the development bank, to lend to MFIs. Access to COFIDE’s credit linescreates a disincentive to savings mobilization.


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Short of prohibiting deposit-taking altogether, there are some intermediatepositions that may be worth considering. There are four general categories ofdeposits:

1. Deposits of members or credit clients

2. Government deposits, such as from a development bank or a wholesalefinancial institution

3. Bank loans, certificates of deposit, and wholesale funds in the privatemarket

4. Small retail savings, which is further differentiated into time deposits,passbook savings and demand deposits

Each category of deposits could be authorized with different standards, such as theminimum capital requirements, capital to asset ratios, and the level of supervision.

In Bangladesh, unregulated microfinance institutions are allowed to mobilizedeposits, but only from their borrowers. Regulators feel that it is not necessary toregulate these institutions since the outstanding balance on loans usually exceedsthe deposit amount. This logic assumes that, if the institution fails, most clientswould be net beneficiaries and therefore are not in need of protection. From theinstitution’s perspective, the disadvantage of this approach is that it would notlikely be able to fund all of its loan portfolio from retail savings.

In Peru, with a considerably lower minimum capital requirement, the emphasis is toopen the market to all comers but to shield small savers from potentially riskyinstitutions by not authorizing deposit taking until the MFI demonstrates excellentportfolio management and sound institutional capacity. Measures similar to thoseadopted in the BCEAO guidelines, which permit deposit-taking but limit theexposure of deposited funds, may serve as a possible middle ground to encouragesavings services for the informal sector while protecting depositors.

Should an MFI that does not mobilize savings be regulated? Most of the expertswho advised this study conclude that regulation is necessary only when depositsare taken from the general public. However, the EDPYME regulation in Peruprovides an example of a specialized law that has been developed for transitionalpurposes. It allows regulators to become familiar with the MFI and its capacity—and vice versa—thereby laying the groundwork for authorizing deposit-taking at alater date. This approach is only appropriate if this category is not used as ajustification for imposing regulation on institutions that do not plan to mobilizesavings in the future.

In a few countries, like South Africa, saving opportunities for low incomecommunities are plentiful. If there is heavy competition for depositors, MFIs mayrealize that it is not cost effective for them to offer savings. In that case, assumingthe institution can fund its growth through other channels, they may not want tomobilize deposits. It is probably not necessary to regulate these institutions,


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although they may require some recognition in order to access wholesale capitalmarkets.

Standards of EntryWhether established as specialized microfinance institutions or within existingguidelines, defining the appropriate standards of entry for microfinance is a criticalchallenge for regulators. How many regulated MFIs do the banking authoritieswant to encourage? Given the limited human, technical and financial resources ofbank superintendencies, how many MFIs can be effectively supervised?

It can be argued that the standards of entry should be relatively low, such asUS$25,000 in Indonesia, US$265,000 in Peru, or in West Africa where there is nominimum capital requirement, thereby opening the way for considerablecompetition in this market. Others contend that MFI owners must demonstratesubstantial financial resources to reduce high risk behavior, and therefore therequirement should be set higher. While this financial depth can support anorganization in crisis, it limits the number of entrants to the microfinance market.

In several countries, there already exist hundreds of institutions that providemicrofinance services. Yet, given the constraints on regulators to supervisespecialized financial intermediaries effectively, an argument can be made in favorof fewer, well-managed institutions. It is the regulator’s responsibility to establishreasonable standards of entry, not necessarily barriers to entry, and to fosterprofessionalism in this emerging segment of the financial services industry. Ratherthan attempt to reach all MFIs, once reasonable entry standards are defined, theregulators should place their emphasis on institutions with the potential to obtainsignificant scale.

In most countries, it is inappropriate for MFIs to have the same minimum capitalrequirements as a commercial bank. The small loan sizes and dispersion of creditrisk over tens, or hundreds, of thousands of unrelated borrowers do not justifylarge capital cushions. If the minimum capital requirement for a bank in a countryis high, and it is not possible to create exceptions within the existing regulatoryframework, then this would be a strong argument for establishing a specialmicrofinance category. Where the minimum capital requirement is not excessive,and regulation and supervision practices can be tailored to the unique risk profileof MFIs within the existing regime, then a special category may not be necessary.

It is worth noting that K-Rep and BancoSol under the existing regulations, andACP under special regulations, all significantly exceeded the capital required tocreate a financial institution as a way of demonstrating their commitment andseriousness.


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Capital to Asset RatiosSince MFIs are new types of financial institutions, and there is not sufficientevidence of how they will weather economic crises, it is suggested that the gearingmultiples for MFIs should be more conservative than those recommended in theBasle Accord for standard commercial finance institutions. This conservativeapproach is appropriate because regulators have limited experience with MFIs, andbecause many MFIs have not yet demonstrated a track record of consistentperformance.

How conservative should the gearing multiples be? This is widely debated. Someargue for gearing multiples in the 5:1 range or even lower; others contend that an8:1 multiple is more appropriate, and that anything lower would unduly constrainthe profitability of MFIs. Alternatively, the permitted gearing multiple could beincreased as the MFI demonstrates a stable performance track record. Regulatorsneed to balance the objective of requiring an adequate capital cushion whilepermitting sufficient leverage to produce returns on equity that would attractinvestors.

4.3 Suggestions for Specialized Microfinance InstitutionsIn countries that seek to establish specialized microfinance institutions, a numberof factors should be considered. It is important to note that the experience to dateis too recent to offer conclusive recommendations. The following suggestions areoffered for discussion purposes for countries interested in establishing a specialcategory for microfinance:

Authorize services that are commensurate with the demonstrated institutionalcapacity and the capital at risk

For a start-up institution without a performance track record, or whererelatively low capital requirements are specified, the range of financial servicesauthorized (e.g., deposit-taking and foreign exchange transactions) should belimited. In some cases, if deposit-taking is authorized, it could be limited bythe types of savings instruments or by other means.

Create a path toward institutional growth

Permitting MFIs to take deposits allows them to provide the target marketwith a much needed service, while establishing the institutional capacity toreceive deposits and engage in financial intermediation. If regulations restrictdeposit-taking capacities of MFIs, these services should be expanded as theinstitution demonstrates its capacity by maintaining its assets. Guidelinesshould permit institutions to strive to become full service financialintermediaries.


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Set appropriate minimum capital and capital adequacy requirements

Regulators should set minimum capital requirements to establish standards ofentry that qualify serious investors and discourage risky market entrants. Atthe same time, minimum capital requirements that are too high would undulyserve as a barrier for the establishment of these kinds of institutions and thedelivery of financial services to the informal sector. In addition, with youngMFIs, the gearing ratio should be more conservative than that which is appliedto commercial banks. Capital adequacy levels should reflect the higher riskprofile of this relatively new segment of the financial services industry.

Permit various types of microfinance institutions

Although MFIs target common markets and provide similar products andservices, there are several different institutional forms. For example, mutualistorganizations, non-governmental organizations and village banks all providemicrofinance services. Any guidelines adopted should be flexible enough to beused by several institutional types that serve this market. The concern with theWest African regulation is that it requires MFIs to conform to the credit unionmodel. This level of specificity may stifle innovations that are necessary toprovide microfinance in a cost effective manner.

Allow a flexible maximum loan size

Most legal and regulatory guidelines for specialized microfinance institutionsestablish a maximum loan size for regulated MFIs as a risk management tool.Such limits, however, should be set relatively high and based on a percentageof assets or equity rather than a specific value. Successful MFIs have found itto their advantage to continue to serve their best clients as their financingrequirements increase. Establishing rigid maximum loan limits would cut offan MFI from its most successful and profitable borrowers. With the PFF inBolivia, a loan may not exceed 3 percent of the institution’s net worth. Thisdisperses the credit supply of the institution and reduces the concentration risk.If the MFI wants to make larger loans to its successful clients, then it needs toincrease its equity base.

Address the definition of collateral

The Bolivian Private Financial Fund regulations define a broader range ofacceptable collateral than is recognized by standard commercial financialinstitutions. By formally recognizing peer guarantees, character references andpersonal movable assets (e.g., jewelry, appliances and furnishings), theguidelines enhance the MFI’s ability to serve its target market and to improvethe quality of loan security it can arrange. By acknowledging a broader rangeof security, the MFI is not penalized for having a portfolio of unsecured loans.Regulators are likely to have reservations about the use of movables ascollateral since they are likely to be re-moved before they can be seized. It willbe useful to monitor the success of countries that are testing this approach tosee if it is indeed successful.


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5. SUPERVISION OF MICROFINANCE INSTITUTIONS

Whether established as a specialized MFI, as a standard commercial bank or afinance company, the supervision of microfinance portfolios presents a challengedue to the volume of small transactions, the lack of conventional security and loandocumentation, and the decentralized operations. The institutional capacity of thebank superintendency to supervise these unconventional financial intermediarieseffectively, and the availability of financial resources to do so, provide additionalchallenges. While the lessons from the microfinance industry are still emerging,experience from the field provides some insights into effective MFI supervisionstrategies. This chapter considers a hybrid approach to supervision, and providesadditional suggestions for supervising microfinance institutions.

5.1 The Hybrid Approach to MFI SupervisionGiven the limited human and financial resources of supervisory agencies, somecountries are using a hybrid approach to the supervision of MFIs in whichresponsibilities are delegated to third parties. This is logical since the supervisionof microfinance portfolios requires different approaches and different sets of skillsthan supervising commercial banks. Because the value microfinance portfolios aresignificantly smaller than those of traditional banks, and therefore pose less of athreat to the stability of the financial system, it is understandable that bankingsupervisors would be willing to delegate responsibility for monitoring theirperformance. In addition, because most countries do not have a critical mass ofMFIs to form a peer group, it may be useful to involve third-parties who cancompare microfinance institutions on a regional or international basis.

This approach requires further analysis. It is possible that this is a more costeffective approach, but is it sufficiently vigilant? An important drawback of thehybrid approach is that it does not build internal capacity in the superintendency tomonitor microfinance over the long-term. In the examples below, from Indonesiaand Peru, the bank superintendency has contracted a third party to perform someor all of the supervisory functions. In Indonesia, a third party, Bank RakyatIndonesia, supervises village banks; in Peru, with the technical assistance of aGerman consulting firm, a federation of municipal banks assists thesuperintendency in monitoring its members. It is also worth considering otherthird-parties for this role, such as auditors and microfinance support institutions.50

50 The credit union movement also has extensive experience with third-party supervision. Thisexperience should also be considered in determining if this approach is appropriate for MFIs.


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IndonesiaIn Indonesia, the banking law provides the power to grant licenses to the Ministryof Finance, while regulatory policy and supervision authority remain with the BankIndonesia.51 Technically, Bank Indonesia is responsible for supervising all financialintermediaries in the country; in effect, the supervision of more than 8,000 smallholder village banks is conducted under a variety of arrangements.

The Unit Desa division of BRI supervises its own branches through 15 regionalaudit offices. Reports are submitted daily (trial balance), weekly (liquidity report),monthly (progress reports and financial statements), along with reports submittedquarterly, semi-annually and annually to the regional management and auditors.

Besides supervising its own unit system, BRI’s Small Business and CooperativeDivision is under contract with Bank Indonesia to supervise more than 5,000 othervillage banks (BKDs) that are not part of its system.52 The supervision by BRI isfunded through a levy charged to the village small holder banks. The divisionmaintains supervisors and bookkeepers. There is one supervisor for every 11village banks, and they make monthly visits. Each bookkeeper is assigned to fourBKDs, and they visit these institutions more frequently. The supervision is not aselaborate as that performed on BRI’s own units, but it includes reviews of theportfolio quality, liquidity, profit and loss statements and balance sheets.

Another class of financial institution in Indonesia, village-owned banks, issupervised by the provincial banks. Even with many institutional partners in thesupervision of MFIs, Bank Indonesia’s supervisory responsibilities remain adaunting challenge. In late l996, the public press claimed that several hundred ofthe more recently established village banks, supervised by Bank Indonesia itself,have not been effectively monitored and are encountering difficulties.

PeruThe sixteen municipal banks in Peru, which were founded with the support ofGerman development assistance (see section 4.1 above), are supervised by both thebank superintendency and FEPCMAC, the federation of municipal banks.FEPCMAC, established in l987, is mandated to audit and control the operations ofthe municipal banks and to provide each bank with specific support, training andassistance as required. Consultants from IPC, the German consulting firm, work inclose conjunction with the federation to monitor the needs of individual municipalbanks and to review the results of regularly conducted audits.53

51 Bank Indonesia is the central bank of Indonesia52 According to sources at Bank Rakyat Indonesia, BRI’s authority and responsibility over thevillage banks dates back to l929.53 In 1996, this arrangement with IPC was being reevaluated.


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The FEPCMAC receives from the individual municipal banks monthly, quarterlyand annual unaudited financial reports including income statements, balance sheetsand portfolio information. It is important to note that the supervision and auditsperformed by the federation do not replace the supervision and audits performedby the appropriate units of the Peruvian bank superintendency. Nevertheless, theservices provided by the federation significantly enhance the reliability and qualityof financial reporting presented by the municipal banks to the superintendency. Ithas been suggested that a similar federation for EDPYMEs, if established, couldprovide a valuable service.

5.2 Suggestions for Appropriate Supervision54

There is general agreement among microfinance practitioners regardingrecommendations for appropriate portfolio supervision. The volume oftransactions and the difference in loan documentation in microfinance institutionsmake traditional methods for portfolio supervision unwieldy and ineffective.Instead, supervision—either by banking supervisors, internal and external auditors,and/or third parties—should consider the following guidelines.

Assess the performance of the portfolio as a whole

Traditional supervision methods entail a review of loans that are selected forexamination because of their size, risk concentration and participation ofrelated parties. The key to effective supervision of microfinance institutions,with thousands of small loans, is to consider the performance of the portfolioas a whole. Statistical trends of subsets of the portfolio, such as by branch orloan officer, should be examined instead of an in-depth review of a smallnumber of cases.

Monitor “trigger” indicators as an early warning system

The potential volatility of microfinance portfolio quality requires carefulmonitoring. Since quality can deteriorate quickly, it is useful to monitor“trigger” indicators that will raise red flags if possible delinquency antecedentsare outside their normal ranges. For example, a sudden increase in clients, staffturnover, changes in management or specific recovery rate deviations couldprecede a spike in delinquency. By monitoring leading indicators, supervisorsmay anticipate changes in future performance.

Examine the validity of the computerized portfolio management system

Because of the high loan volumes and the central role of tight delinquencymanagement in assuring the viability of the institution, management mustdepend on computerized portfolio management systems to track overallportfolio performance. Supervisors should carefully examine the validity,

54 Christen stressed many of these points in his presentation at the USAID-sponsored workshopfor Commercial Banks in Microfinance, November 1996.


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accuracy and reliability of the portfolio management information system. Ifsupervisors have determined that the MIS is accurate, then they will not needto rely heavily on on-site visits to assess the quality of the portfolio, whichshould reduce the costs of supervision.

Compare the operating methods applied by field and administrative personnel inpractice to the operating policies described in the institution’s operating manuals

In addition to an examination of the MIS, effective supervision should includean operational audit to assess how the actual lending methodologies compareto the established methods as defined in the institution’s operating manuals.While institutions may choose to refine their methods, once appropriatelytested, inconsistencies or deviations in operating methods should be noted.Since it is not practical for bank examiners to monitor policy implementation,and it not likely that they would have the technical skills to do so,superintendents would have to rely on internal auditors and management toperform this function.

Conduct spot checks on samples of the borrowers

While the emphasis is on the performance of the portfolio as a whole, it is alsonecessary to visit a statistically valid sample of the borrowers. In most cases,internal auditors would assume this responsibility, but supervisors shouldensure that it takes place. The purpose of these checks is three-fold: (a) todetect fraud by identifying ghost borrowers; (b) to test if loan officers areproperly implementing the lending methodology; and (c) to ensure that loanpractices, such as loan rescheduling, are consistent with the institution’spolicies.

Adopt conservative risk-weighting and provisioning policies

In many countries, regulated MFIs, whether they operate as commercial banksor specialized intermediaries, apply the same risk weighting and provisioningpolicies as pertain to consumer finance loans.55 These policies should bereviewed to ensure that an appropriately conservative approach is adopted,particularly given the unconventional security used by most MFIs.Provisioning policies should consider the average loan maturity of theportfolio. More aggressive provisioning is called for with the shorter averagematurity of most MFI portfolios.56

MFIs pay for the supervision services

Typically, traditional financial institutions contribute to the cost of theirsupervision. A similar approach should be used with MFIs. If fees are charged

55 Los Andes (Bolivia) and ACP (Peru) have both chosen to employ more conservativeprovisioning policies than stipulated for consumer finance.56 A three month loan that is two months overdue is more likely to default than a 60 month loanthat is two months overdue.


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based on the size of the portfolio, then large commercial banks would cross-subsidize the costs of supervising microfinance portfolios—which mostmicrofinance practitioners would probably welcome. In addition, the costs ofsupervising microfinance portfolios could be kept down if supervisors relyheavily on well-trained auditors, both internal and external. Nevertheless,donor support may be necessary to train supervisory and audit personnel andto develop appropriate auditing and supervision protocols.

5.3 Recommendations from IndonesiaIn Indonesia, bank supervision is highly decentralized and performed by a relativelylarge number of examiners. Based on this experience, the management of BankRakyat Indonesia urges the adoption of simple guidelines that are easilyunderstood and applied by local branch management and examiners. Specificrecommendations from the Indonesia experience include:

MFIs should recognize revenue on the more conservative cash basis rather thanan accrual basis

Although formal banking institutions use accrual accounting to provide aprecise rendering of the financial position of a financial institution, without acomputer system it is more complex to administer than cash accounting. In anenvironment such as Indonesia, where many bank branches are notcomputerized and banking supervision is highly decentralized, revenue shouldbe recognized on a cash basis. If, however, the branch offices arecomputerized, then the more accurate accrual method is appropriate.Furthermore, to be effective, accrual accounting requires that appropriatepolicies regarding income on non-performing loans be introduced.

Loan classification and provision guidelines should be based on simple,measurable factors (e.g., days delinquent) rather than allowing individual branchmanagers to use judgment in the classification process

In broad, decentralized systems, operating guidelines should be easilymeasured to ensure consistent application of uniform practices.

Taxable income base should reflect actual provisions taken instead of settingarbitrary limits to the provisions applied by MFIs:

In some countries, to curtail under-reporting of income, the formula fordefining income used to calculate tax obligations is based on standardizedprovisioning policies. If an MFI elects to adopt more conservativeprovisioning, for tax purposes their income is calculated as if the standardizedprovisions were used. This serves to penalize MFIs that adopt moreconservative provisioning practices.

The supervision of regulated microfinance institutions is a relatively new practice.Worldwide, there is little experience of bank superintendencies supervising such


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institutions. Where the regulated MFIs are more mature, supervisoryresponsibilities are often shared or delegated to third parties. Bank Indonesia hasdelegated much of its supervisory responsibilities to BRI; in Bangladesh,supervision of Grameen Bank occurs mostly through the government’sparticipation on the board of directors. In Peru, for the past ten years thefederation of municipal banks has played a valuable supporting role to the banksuperintendency. In most countries, there remain serious questions regarding theavailable resources for bank superintendents to pursue the supervision methodsthat are most appropriate to MFIs. Creative approaches to making availableeffective supervision, through sub-contractual arrangements or other means, meritfurther exploration.


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6. RECOMMENDATIONS

Microfinance institutions have demonstrated considerable resilience, flourishingoutside the regulated environment. As the number of institutions increases, and asthe MFIs have grown in scale and complexity, regulators may seek the means tosupport their growth, while safeguarding the financial system and protecting theinterests of MFI clients, the most economically vulnerable sectors of thepopulation.

While appropriate regulatory approaches must be consistent with the regulatoryframework of a given country, this study points to field lessons that illuminateappropriate regulation of this segment of the financial market. The essence ofthese lessons is to consider the risk profile of microfinance institutions andrigorously apply prudential guidelines where MFIs are vulnerable, but to offerflexibility in risk control measures that do not apply to the microfinance sector.Such effective regulation can be accomplished through exemptions andmodifications to existing financial sector guidelines or through the establishment ofspecialized regulatory regimes.

Whichever means is adopted, regulators should be cautious not to move too hastilyto establish regulations, or to establish regulations based only on one institutionalmodel. Microfinance has evolved over the past twenty years in a largelyunregulated environment. Microfinance institutions have been free to innovatefinancial service methodologies appropriate to the characteristics of their targetmarket. There is a danger that regulations designed for the risk profile ofcommercial banks may box MFIs into practices that require replicating traditionalbanking practices, thereby losing their ability to reach their target market.

There is also a danger that the proliferation of MFIs, in response to a seeminglylimitless market for microfinance services, may exceed the regulator’s capacity ofsupervision. Yet, once MFIs are regulated entities, depositors may not adequatelyevaluate their risk. It is necessary to find a balance; regulators should consider aline below which the financial markets are better left unregulated and focus theirattention on those institutions with the potential to obtain significant scale. Inaddition, until regulators develop an expertise with microfinance, it is probablypreferable not to license too many institutions.

This chapter provides specific regulation and supervision recommendationsdesigned to address the unique risk profile of MFIs outlined in Chapter 2. Thesepoints are relevant in both cases: if an MFI is accommodated within an existingregulatory framework and in the design of a special category for microfinance.


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6.1 Specific Recommendations to Address MFI Risk ProfileLeading microfinance institutions have demonstrated that it is possible to managethe four-point risk profile of a microfinance institution. Regulators and supervisorsplay an important role in this process by recognizing the inherent strengths andvulnerabilities of MFIs. Measures to address the MFI risk profile are outlinedbelow.

Ownership and Governance RiskRegulators should encourage meaningful participation of private investors,particularly local business leaders.

Bank regulators can assume a highly constructive role to manage ownershipand governance risks by encouraging the right composition of MFI ownership.The perspective, contacts and credibility of local private investors couldcontribute significantly to the stability of an MFI. Furthermore, if privateinvestors have a significant percentage of their own resources at risk, they canbe an important source of local governance and a valuable resource if theinstitution encounters difficulties.

MFIs benefit from the participation of several significant shareholders who bringdiverse backgrounds and perspectives to the governance process.

In addition to private investors, regulators should encourage investment byother private or public development-oriented institutions with microfinance orrelated development finance experience. Many microfinance institutionsexamined were developed by non-governmental organizations that engaged inthe delivery of financial services. The NGO typically invests its alreadyestablished portfolio as its source of capital to the new financial institution.While this places the NGO in the position of majority shareholder, this is notadvisable. Regulators should seek a balance of experience and qualificationsamong shareholders.

Successful arrangements between the NGO owners and the regulated MFI can beattained if the structure adheres to certain basic principals, includingtransparency, arms-length transactions, honest transfer pricing and operationalindependence.

The NGO should maintain its identity and mission with a clear definition ofservices it provides to the regulated financial intermediary, and vice versa. Theregulated MFI must maintain independent management and oversight of itsfinancial services. In addition, banking supervisors should require reporting ofall business dealings between the NGO and the financial institution. Byapplying these principles, effective coordination between the NGO andregulated MFI can be obtained.


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Regulators can require that board composition include individuals professionallyprepared to define sound policies and to oversee management.

Nevertheless, given the mix of MFI ownership, it is common for somedirectors not to have pecuniary interests in the performance of the MFI. Tocompensate for this lack of financial risk, the directors could be held legallyliable for the performance of the MFI, as is applicable to directors of privatesector companies. This may make it difficult to find directors, but there shouldbe some ramifications for not fulfilling their responsibilities. For this to work,the legal system needs to identify what constitutes gross negligence, such asnot appointing an internal auditor or failing to determine the quality orreliability of reported financial information.

Regulators can introduce measures to compensate for the owners’ limitedcapacity to respond to additional calls for capital.

This can be addressed by the following options: (i) increasing the capitaladequacy requirements; (ii) establishing additional reserve funds; (iii) limitingdividend distribution until capital benchmarks are reached; and (iv) requiringstandby financing commitments by MFI owners. The capital structure of theMFI should anticipate this limited availability of additional resources.

Management RiskRegulators should ensure that well-trained internal and external auditors areperforming their responsibilities accordingly.

Regulators should require MFIs to maintain strong internal auditing capabilitiesand aggressive internal auditing procedures, including spot checks onborrowers. Guidelines should also establish the performance requirements ofexternal auditors. Because of the decentralized service delivery methods, andthe delegation of considerable decision-making to field personnel, adequatemeasures of internal control are critical to detect and prevent fraud.

MFIs should apply consistent financial service methodologies.

Supervisors can reasonably require MFIs to document their operating methodsand to hold the organization accountable to their operating procedures, as longas flexibility to adjust them over time is not hampered. Senior managementmust train and supervise mid-level management, introduce appropriatereporting systems, and maintain adequate communication systems so thatuniform policies and procedures are adopted. New products and services,including the application of new service delivery methods, should be welltested before implementation on a wide scale.


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Portfolio RiskBank regulators should accept flexible definitions for loan security that enhancerepayment incentives.

Microfinance lending methods rely on repayment incentives and non-traditionalcollateral—such as access to repeat loans, peer pressure, potential loss ofpersonal assets and personal relationships with loan agents—instead ofconsidering loan collateral a potential secondary source of repayment.Sufficient experience is now documented to demonstrate that such repaymentincentives can result in very low delinquencies and permit the delivery offinancial services to sectors of the economy that do not have access toconventional collateral.

The accuracy of portfolio management information systems should be verified.

The most effective means of controlling MFI portfolio risk is to ensure theadequacy of the portfolio MIS, to use statistical analysis to evaluate the overallperformance of the portfolio, and to verify the results with random portfoliochecks. Adequately designed, current and accurate information systems areessential for managing the portfolio risk of microlenders because of the volumeof transactions, their short terms, frequent repayment schedules anddecentralized operations.

Regulators should adopt aggressive loan provisioning policies.

The provisioning policy is an empirical issue that should be determined on acountry by country basis. Loan provisioning policies should be commensuratewith loan maturities; risk-weighting that considers the quality of security; andstandard methods that can be easily and consistently replicated. The shortaverage maturities of most microfinance institutions indicates that provisioningapplied to a microfinance portfolio should reasonably be more conservativethan policies adopted for commercial banking. A 60-day delinquency of a 90-day loan may be a greater risk than a 90-day delinquency on a five year loan.Regulators may also want to consider different approaches to the risk-weighting of MFI portfolios. For example, different risk weighting may beassigned to those assets secured by character reference. Most importantly,regulators should encourage the adoption of standard loan classificationprocedures. By limiting management discretion, it is possible to obtain anaccurate and consistent assessment of portfolio quality.

Regulators should not require significant documentation for microloans.

Successful MFIs have demonstrated that simple applications are all that isrequired. In MFIs with very short-term loans, repeat loans may be approvedwithout a business assessment for clients in good standing. The approval of aloan application relies more on the client’s repayment history and thequalitative assessment of loan officer than on any quantitative information in


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the application. Requiring more documentation than a successful MFI deemsnecessary can add significant costs and undermine its profitability.

New IndustryRegulators should closely monitor MFIs that dramatically surpass the growthprojections presented in the license application.

Most successful MFIs operate in a market that, until now, has beensignificantly under-served. As microfinance services extend to the informalsector, the demand is often very strong and an MFI has an opportunity tosustain exponential growth rates. The experiences of Finansol and otherinstitutions have indicated that rapid growth can lead to a deterioration in loanportfolio quality and should be closely monitored.

New products and services must be well tested before implemented on a broadscale.

It may be appropriate to limit the number of new products or services that areintroduced at any one time. Each innovation in a methodology must becarefully evaluated to determine how the new methods will influence theoriginal service delivery. Furthermore, an institution’s capacity to implementmany new products and services, while continuing to grow their existingproduct lines, must be considered.

Regulators can safeguard public interest, while contributing to the institution’spotential success, by limiting the products and services that MFIs offer.

The challenge facing MFIs is to conduct a large volume of very smalltransactions, and to do so profitably. Given this challenge, it is appropriate tolimit the products and services provided by MFIs. However, as an institutiondemonstrates its capacity and builds a track record of success, it should bepermitted to provide additional services required by its market.

Regulators should require MFI managers to be well versed in both traditionaland micro finance.

Since management is the first line of defense against a failing portfolio, it isreasonable to have high standards for the management of MFIs. Whilemicrofinance managers can be created through training, it requires an adequateinvestment in time and resources to ensure that MFI managers are wellprepared for their responsibilities.

6.2 ConclusionThousands of dedicated microfinance institutions have emerged around the world.They have developed innovative and unconventional lending methodologiesdesigned to meet the specific characteristics of microenterprises and low income


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communities. By doing so, some MFIs have demonstrated that microfinance isprofitable. Through the provision of these services, MFIs deepen the financialsystem and expand the economic contribution of what are normally consideredmarginal communities.

As MFIs mature, many are realizing that they need to enter the formal financialsystem to fund their growth and to provide the diversity of financial servicesdemanded by their target market. But, just as traditional lending techniques areinappropriate for the characteristics of microenterprises, traditional bankingregulation and supervisory practices are ill-suited to the unique risk profile of amicrofinance institution.

While it is not possible nor desirable to regulate all microfinance institutions, thereare an increasing number of MFIs that are reaching significant scale, intend tomobilize savings and merit further consideration by bank regulators. Thisdocument has reviewed some of the experiences to date of jurisdictions that haveattempted to shape regulation and supervision to the specific characteristics ofmicrofinance. A range of responses were considered, including making exceptionsto existing regulations, creating special regulatory categories for microfinance anddelegating supervisory responsibilities to third parties. This study did not assessthe costs, risks or effectiveness of one approach over others. The experience todate is insufficient to offer such an assessment—however it will certainly bewarranted in the near future.


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BIBLIOGRAPHY AND SUGGESTED READING

Alliance of (South African) Micro Enterprise Development Practitioners. 1996. “A PositionPaper presented by the Alliance of Micro Enterprise Development Practitioners on TheReview of the Usury Act.”

Benston, George, Robert Eisenbeis, Paul Horvitz, Edward Kane, and George Kaufman. 1986.Perspectives on Safe & Sound Banking: Past, Present, and Future. Cambridge, MA:MIT Press.

Boomgard, James and Kenneth Angell. 1994. “Bank Rakyat Indonesia’s Unit Desa System:Achievements and Replicability.” In Otero and Rhyne, editors, The New World ofMicroenterprise Finance: Building Healthy Financial Institutions for the Poor. WestHartford, CT: Kumarian.

Burnett, Jill. 1995. “Individual Micro-Lending Research Project Case Study: The CajaMunicipales of Peru,” CALMEADOW, unpublished manuscript.

Castello, Carlos, Katherine Stearns and Robert Christen. 1991 “Exposing Interest Rates: TheirTrue Significance for Microentrepreneurs and Credit Programs.” ACCION DiscussionPaper No. 6.

Chaves, Rodrigo A. and Claudio Gonzalez-Vega. 1996. “The Design of Successful RuralFinancial Intermediaries: Evidence from Indonesia” in World Development, Vol. 24,No. 1, pp. 65-89.

Chaves, Rodrigo A., and Claudio Gonzalez-Vega. 1994. “Principles of Regulation and PrudentialSupervision and Their Relevance for Microenterprise Finance Organizations.” In Oteroand Rhyne, editors, The New World of Microenterprise Finance: Building HealthyFinancial Institutions for the Poor. West Hartford, CT: Kumarian.

Chaves, Rodrigo A. and Claudio Gonzalez-Vega. 1992. “Indonesia: Regulation and Supervisionof Rural Financial Intermediaries, Chapter IV, “Report for the FID in Indonesia,”October, 1992.

Christen, Robert Peck, Elisabeth Rhyne, Robert Vogel, and Cressida McKean. 1995.“Maximizing the Outreach of Microenterprise Finance: An Analysis of SuccessfulMicrofinance Programs.” Washington, DC: United States Agency for InternationalDevelopment.

Christen, Robert Peck. 1997. “Issues in the Regulation and Supervision of Microfinance,” inRachel Rock and Maria Otero, editors, From Margin to Mainstream: The Regulationand Supervision of Microfinance. ACCION International, Monograph Series, No. 11.

Credit and Development Forum. 1996. “Savings and Credit Information of NGOs (Data ofMarch and June, 1996),” Vol. 2. No. 1. Dhaka, Bangladesh.

Dewatripont, Mathias, and Jean Tirole. 1993. The Prudential Regulation of Banks. Cambridge,MA: MIT Press.

Drake, Deborah, and Maria Otero. 1992. Alchemists for the Poor: NGOs as FinancialInstitutions. Cambridge, MA: ACCION International.

Economist, The. April 12-18, 1997. “Banking in Emerging Markets.”


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Fry, Maxwell. 1988. Money, Interest and Banking in Economic Development. Baltimore, MD:Johns Hopkins University Press.

Glosser, Amy. 1994. “The Creation of BancoSol in Bolivia.” In Otero and Rhyne, editors, TheNew World of Microenterprise Finance: Building Healthy Financial Institutions for thePoor. West Hartford, CT: Kumarian.

Gonzalez-Vega, Claudio, with Mark Schreiner, Richard L. Meyer, Jorge Rodriguez, and SergioNavajas. 1996. “Banco Solidario S.A.: The Challenge of Growth for MicrofinanceOrganizations.” Columbus, OH: Ohio State University, Rural Finance Program.

Khandker, Shahid, Baqui Khalily and Zahed Khan. February 1994. “Is Grameen BankSustainable?” HRO Working Paper: 23.

MicroFinance Network, Member Statistics, January 1997.

Otero, Maria and Elisabeth Rhyne, eds. 1994. The New World of Microenterprise Finance:Building Healthy Financial Institutions for the Poor. West Hartford, CT: Kumarian.

Polizatto, Vincent P. 1990. “Prudential Regulation and Banking Supervision: Building anInstitutional Framework for Banks.” Washington, DC: World Bank.

Rhyne, Elisabeth and Maria Otero. 1994. “Financial Services for Microenterprises: Principlesand Institutions.” In Otero and Rhyne, editors, The New World of MicroenterpriseFinance: Building Healthy Financial Institutions for the Poor. West Hartford, CT:Kumarian.

Rhyne, Elisabeth and Linda Rotblatt. 1994. What Makes Them Tick? Exploring the Anatomy ofMajor Microenterprise Finance Organizations. Cambridge, MA: ACCIONInternational.

Robinson, Marguerite. 1994. “Savings Mobilization and Microenterprise Finance: TheIndonesian Experience.” In Otero and Rhyne, editors, The New World ofMicroenterprise Finance: Building Healthy Financial Institutions for the Poor. WestHartford, CT: Kumarian.

Rock, Rachel and Maria Otero, editors. 1997. From Margin to Mainstream: The Regulation andSupervision of Microfinance. ACCION International, Monograph Series, No. 11.

Rosenberg, Richard. 1994. “Beyond Self-Sufficiency: Licensed Leverage and MicrofinanceStrategy.” USAID/Bolivia. Photocopy.

Rosenberg, Richard. 1996. “Occasional Paper No. 1: Microcredit Interest Rates,” CGAP, August1996.

Strauss Commission. 1996. “Interim Report of the Commission of Inquiry into the Provision ofRural Financial Services (in South Africa).” March 1996.

Sugianto and Marguerite S. Robinson. 1996. “Commercial Banks as Microfinance Providers.”Unpublished paper prepared for the USAID Commercial Banks and MicrofinanceConference, Washington, DC.

Tati, Sizwe, Khula Enterprise Finance Ltd. Presentation at the Microcredit Summit inWashington, DC, February 3, 1997.

Trigo Loubiere, Jacques, Superintendent of Banks and Financial Institutions in Bolivia, in RachelRock and Maria Otero, editors, From Margin to Mainstream: The Regulation andSupervision of Microfinance. ACCION International, Monograph Series, No. 11.

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Yaron, Jacob. 1994. “What Makes Rural Financial Institutions Successful.” World BankResearch Observer. Vol. 9, No. 1. January. Washington, DC: World Bank.

PUBLICATIONS FROM THE MICROFINANCE NETWORK:

CONFERENCE PAPERS:• Current Governance Practices of Microfinance Institutions• Moving Microfinance Forward 1998*• Establishing a Microfinance Industry 1997*• Key Issues in Microfinance 1996*

OCCASIONAL PAPERS:• The Regulation and Supervision of Microfinance Institutions: Experience from

Latin America, Asia and Africa by Shari Berenbach and Craig Churchill,1997.**

• The Regulation and Supervision of Microfinance Institutions: Case Studiesedited by Craig Churchill, 1997.*

*Also available in Spanish.

**Also available in French and Spanish.

The MicroFinance Network

The MicroFinance Network is a global association of leading microfinance practitioners. Networkmembers are committed to improving the lives of low-income people through the provision ofcredit, savings and other financial services. The Network believes that this sector should beserved by sustainable microfinance institutions. The MicroFinance Network is a vehicle foraccomplished institutions to provide each other with technical assistance and to learn from eachothers’ experiences.

Non-governmental Organizations Support Institutions Regulated Financial InstitutionsASA, Bangladesh ACCION International, USA ACEP, SenegalABA, Egypt CALMEADOW, Canada BancoSol, BoliviaBRAC, Bangladesh Banco del Desarrollo, ChileCHISPA, Nicaragua BRI Unit Desa, IndonesiaEmprender, Argentina CERUDEB, UgandaFED, Ecuador Citi Savings and Loans, GhanaFundusz Mikro, Poland Cooperativa-Emprender, ColombiaGet Ahead, South Africa FINAMERICA S.A., ColombiaPRODEM, Bolivia K-Rep Bank, KenyaTSPI, Philippines Mibanco, formerly ACP, Peru

SEWA Bank, India

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